Companies are always looking for a way to measure financial success—and to measure ways to create financial opportunities, as well.
One way to do both simultaneously is via operating leverage, which can tell company financial executives a great deal about the firm’s paths to profit generation, and about any potential financial roadblocks, too.
The degree of operating leverage comes from a company’s larger financial leverage picture, like debt-to-equity and rates of return.
Financial leverage (also known as the debt to equity ratio, or L = D/E) focuses on how much a company is financed by debt versus equity. Basically, the higher the debt level the greater financial leverage. It’s a common calculation—most business people who borrow money are familiar with the term financial leverage.
Operating leverage falls under the same accounting model, but with a twist. While financial leverage steers its calculus toward borrowed money (i.e., debt), operating leverage calculates a business’s fixed versus variable costs.
When a company understands that figure, it’s management team can better comprehend and adjust the impact that the company’s cost structure has on profits, and thus on the company’s level of success.
Investors can use a company’s operating leverage as one more piece of information that indicates the risk profile—and potential investment risk—of the business. While one might not make a decision about when to buy a stock based solely on a company’s operating leverage, it’s a valuable figure to have.
What is Operating Leverage?
Fixed Costs and Variable Costs
No company manufacturers a product without incurring expenses—those are literally the costs of doing business. There are two different types of expenses, fixed and variable expenses.
• Fixed expenses. These are business expenses that never change, like commercial rent, for example. It doesn’t matter how much a company earns or loses in a given month, the amount of rent owed on their lease is set at a fixed rate until the contract expires, at which point the lease can be renegotiated or dropped entirely.
• Variable expenses. These business expenses are triggered when a company sells a product or service, and is paid for the sale by the customer. Such expenses are highly commonplace in business. One example might be the wholesale cost of a product, which can change over time depending on the price of raw materials. Another would be a “work for hire” employee who may or may not stay with the company.
Examples of Hybrid Semi-variable and Semi-fixed Costs
Sometimes costs blend together to create “semi-fixed or semi-variable costs.” For instance, a business may promise a plant supervisor a weekly salary of $1,500, plus 1% of the cost price for every widget produced under that manager’s supervision.
The fixed cost is the manager’s weekly salary of $1,500. That remains the same from pay period to pay period.
The variable cost is the 1% unit production percentage paid to the manager as an income incentive. That 1% payout is largely unknowable when the promise is made, making it a variable cost.
In another example, a company may pay its corporate finance manager a salary, which represents a fixed cost. Yet that same company may also pay its line workers on a production basis, based on a per-product wage formula. In that scenario, the same company may have dual fixed and variable costs in the same cost pipeline (i.e., salaries and wages), making those costs semi-variable and semi-fixed costs.
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High Operating Leverage and Low Operating Leverage: A Comparison
Operating leverage represents the financial “break-even” point to a company, where a company’s costs are equivalent to its sales. There are varying degrees of operating leverage, but in general they are described as high or low.
A company with a large percentage of fixed costs against total costs has high operating leverage: higher total costs and lower profits. In that instance, the company must sell more products or services to cover all fixed and variable costs. High operating leverage means the company’s break-even point is high, but it also means once they pass that point, they’ll increase profits quickly.
A business with a low operating leverage owns a larger percentage of variable costs against total costs; they have lower total costs and higher profits. This gives the company a stronger “leverage” position—it can sell a lower number of goods or services in order to cover costs, and then pursue more profits.
Businesses tend to aim for lower operating leverage, as even in market periods where revenue growth is weak, covering fixed costs is still doable as long as its operating leverage also remains low.
Of course, some business sectors traditionally have higher fixed costs than other business sectors. That’s why corporate financial analysts typically confine their operating leverage comparisons to companies within the same industry.
Operating Leverage and Profit
Mathematically, the formula for operating leverage looks like this:
Operating Leverage = [Quantity (Price – Variable Cost per Unit)] / Quantity (Price – Variable Cost per Unit) – Fixed Operating Cost
For example, say Firm ABC has sold 1,000,000 hammers for $12 each. Firm ABC also has $10,000,000 worth of fixed costs, for expenses on machinery, office computers and equipment, and employees, among other costs. With unit sales at $12 each and $10 million in fixed costs, Firm ABC pays $0.10 per unit to make each hammer.
Here’s what that equation looks like in mathematical terms, and what the operational leverage outcome winds up being:
Operating Leverage = [1,000,000 x ($12 – $0.10)] / 1,000,000 x ($12 – $0.10) – $10,000,000 = $11,900,000/$1,900,000 = 6.26 or 626%
Based on that calculation, a 10% revenue spike will result in a 62.6% operating income increase for Firm ABC.
Operating leverage can be a helpful gauge of a company’s fiscal health and investment risk.
Operating leverage measures any changes—good or bad—in a company’s operating income, due to variables in that company’s sales performance. Even an approximate notion of operating leverage can shine a light on a company’s financial growth and prospects, and help determine profitability and investment risk—in both the short and long term.
Though operating leverage provides valuable information about a company, it isn’t the only piece of information an investor should be aware of.
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