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Understanding operating leverage: Evaluating profit potential and cost dynamics in business

Return on equity, debt-to-equity, and price-to-earnings ratios are commonly used methods for evaluating a company's investment potential. However, one often overlooked measure is operating leverage, which examines the interaction between a company's fixed and variable costs.


What is operating leverage?


Operating leverage is a ratio that sheds light on the relationship between a company's fixed and variable costs. It shows us how each additional dollar of sales impacts a company's operating profit. In simple terms, it helps us understand how a company's operations drive its revenues. Operating leverage efficiently empowers a company to maximize returns by efficiently utilising fixed expenses.


The factors at play: fixed and variable costs


Fixed costs are those expenses that stay constant regardless of sales volume. Think of a factory's monthly rent, which remains the same whether the company manufactures 500 or 5000 units of a product. These costs are unavoidable and must be incurred, no matter the sales. For instance, McDonald's incurs fixed costs such as rent, labour, and utility expenses at each of its stores, irrespective of the number of burgers sold.


On the other hand, variable costs depend on a company's operations, either fixed up to a certain limit or in proportion to its production capacity. Unlike fixed costs, variable costs fluctuate with the number of units produced. Simply put, they increase or decrease in direct proportion to the production volume. Take McDonald's as an example, where items like buns, patties, and fries are used to create the finished product. These variable costs are closely tied to the level of sales. As a result, the more cheeseburgers they sell, the higher the raw material costs they will incur.



The implications of operating leverage


Operating leverage is commonly observed in businesses that require significant investments in fixed assets. It calculates a company's fixed costs as a percentage of its total costs. Consequently, a company with higher fixed costs will have higher operating leverage compared to a company with higher variable costs.


The advantages of high operating leverage can be significant. Companies with high operating leverage can generate greater profits from each additional sale without incurring additional production costs. When a business picks up, fixed assets such as property, plant, and equipment, as well as existing workers, can significantly contribute without incurring extra expenses. This leads to expanded profit margins and accelerated earnings growth.


Visualizing the impact


The chart below from Credit Suisse illustrates the impact on operating profit margin based on changes in revenue under different cost structures.


The cost structure composition and operating profit scalability graph shows how fixed and variable expenses affect the company's operating profit margin.
Source: Credit Suisse

Example


The concept of operating leverage is best explained with an example. HIGH is a company with a higher operating leverage, 75% fixed expenses and 25% variable expenses. LOW is a company with a lower operating leverage, 25% fixed expenses and 75% variable expenses.


Both recorded sales of $1000 and $800 in expenses, giving them a profit of $200.


A 20% increase in sales from $1000 to $1200 would result in a proportional rise in variable expenses.


For HIGH, variable costs would increase from $200 to $240. And for LOW, variable costs would increase from $600 to $720.


The fixed cost for both would remain the same at $600 and $200 respectively.


After achieving sales of $1000 and expenses of $800, generating a profit of $200, a 20% sales increase to $1200 caused variable expenses to rise proportionally, resulting in variable costs of $240 for HIGH and $720 for LOW, consequently leading to an 80% increase in net profits for HIGH and a 40% increase for LOW.

The net profits of HIGH soared by 80%, whereas LOW's net profits experienced a mere 40% increase. This exemplifies the impact of operating leverage. HIGH benefits from a higher percentage of fixed expenses. When expenses don’t grow as sales, the net profit will grow at a significantly higher rate.


Operating leverage has a dual effect. In the case of a company with high operating leverage, a decrease in sales would result in a more substantial decline in net profits as well.


When revenue declines by 20% to $800, variable costs would decline to $160 and $480 for HIGH and LOW respectively.


Operating leverage demonstrates a dual impact, whereby a company with high operating leverage would experience a more significant reduction in net profits in response to a decrease in sales.

HIGH experienced a staggering 80% decrease in net profits, whereas LOW suffered a 40% decline. Even when sales decline, fixed expenses remain constant. When expenses do not decrease as rapidly as sales, the net profit will plummet at a significantly higher rate.


What can we observe?


As you can see from the example, a company with low operating leverage must generate enough sales to cover its fixed expenses before it can start earning profits. Once the company surpasses the break-even point, where all fixed costs are covered, it can begin making additional profits. However, due to higher variable costs, the incremental profit, which is determined by subtracting the variable costs from the selling price, may not be significantly large. When operating leverage is low and fixed costs are minimized, it can be concluded that the company needs to sell a relatively smaller number of units to reach the break-even point.


On the other hand, high operating leverage companies will have a higher break-even point due to the elevated fixed costs. However, the advantage lies in the fact that once the break-even point is surpassed, the company can earn higher profits on each product since the variable costs are significantly lower.


High operating leverage companies face challenges in managing short-term revenue fluctuations because expenses persist regardless of sales levels. This increases risk and limits flexibility, negatively impacting the bottom line. Although high operating leverage can benefit companies during prosperous times, those with substantial costs tied to assets like machinery, plants, real estate, and distribution networks struggle to reduce expenses in response to changes in demand. Consequently, during an economic downturn, earnings can plummet rather than simply decrease.



Can the operating leverage ever be zero?


Operating leverage is zero when a company has no fixed assets. This means that the percentage change in earnings matches the percentage change in sales. As a result, there's no operating leverage.


Case studies


Let's consider the example of Microsoft, a software maker. Most of Microsoft's cost structure consists of fixed expenses associated with development and marketing. Regardless of whether they sell a single copy or millions of copies of their Windows software, the costs remain relatively stable. Therefore, once Microsoft surpasses the point where these fixed costs are covered, every additional dollar generated from sales goes straight to the company's profit. This demonstrates Microsoft's significant level of operating leverage.


In contrast, a retailer like Walmart exhibits relatively low operating leverage. Walmart has lower fixed costs compared to Microsoft, with a significant portion of its expenses allocated to variable costs. The most substantial cost for Walmart is merchandise inventory. With each product sale, Walmart incurs the cost of acquiring that specific item. Consequently, as sales revenues increase, Walmart's cost of goods sold also rises.



How can businesses increase their operating leverage?


A company can boost operating leverage by acquiring more fixed assets. This helps the company have more assets to support its main operations and improves operating leverage. However, this depends on the nature of the business as well because not all businesses can transit their leverage easily. For example, in the case of Walmart, it is not a business that can acquire more fixed assets to increase its operating leverage.


Bottom line


In conclusion, operating leverage is an important metric for evaluating a company's cost structure and its potential impact on profitability. It provides insights into how fixed and variable costs interact and influence a company's operating profit. High operating leverage can lead to greater profits during favourable economic conditions, as fixed costs can be effectively utilized. However, it also poses risks during periods of economic downturns, as fixed costs persist regardless of sales levels. It is important to note that operating leverage itself is neither inherently bad nor good, but its implications should be carefully considered in relation to a company's specific circumstances and industry dynamics.



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