What’s it: Operating leverage shows you the extent to which a company’s operating costs are dependent on fixed operating costs. If the company has high leverage, it shows that the company has a significant proportion of fixed costs. Meanwhile, if it is low, then the proportion of fixed costs to total operating costs is relatively low.
Leverage affects the company’s risk because it affects the sensitivity of the company’s future earnings and cash flows. If the company has high leverage, a small change in sales will significantly impact profits.
Why operating leverage is important
Several reasons are why operating leverage is important:
- Measure the sensitivity of a company’s earnings and cash flow
- Calculating the breakeven point
- Measure the risk of business operations
- The effect on the rivalry of companies in the industry
Measure the sensitivity of a company’s earnings and cash flow
High operating leverage reflects overly sensitive profits. Small changes in sales can result in volatile profits. Costs remain unchanged even if sales increase or decrease. Therefore, when forecasting sales of highly leveraged companies, you should be careful. Even a small deviation will be a big mistake in your cash flow projections.
Conversely, when leverage is low, the proportion of variable costs is higher. A change in sales will cause a change in total costs at a relatively similar percentage. Thus, company profits are more stable.
Calculating the breakeven point
The breakeven analysis helps the company set a target selling price or sales volume at where revenue will equal the total costs. See the formula below; the company makes a profit when the contribution margin (S-VC) is higher than the total fixed cost (FC). The higher the difference between the two, the greater the company’s profits.
When a company generates a significant contribution margin, it can use it to pay fixed costs. The rest represents the company’s profits.
Measure the risk of business operations
Business operating risk shows you the uncertainty about future operating profits. It depends on the stability of the company’s revenue and operating cost structure.
Revenue stability represents sales risk, namely the uncertainty of sales inflows due to fluctuations in its sales volume and prices. If the company’s revenue is relatively stable, we consider the risk of selling to be relatively low. The company’s pricing and marketing strategies are likely effective in dealing with dynamic demand and market competition.
Next, the operating cost structure shows you how high the company is depending on fixed costs. The company has to pay fixed costs such as administrative fees, facilities, equipment, and taxes, regardless of whether the company generates sales or not.
Therefore, if fixed costs account for a significant proportion of the firm’s total operating costs, we consider the firm to have a high operating risk. The company must generate significant sales to cover fixed costs and to make a profit. If it cannot do so, the company incurs significant losses.
Effect on competition
Highly leveraged industries usually have high entry barriers. New companies have to invest significant money to purchase expensive equipment such as machines. Then, they must generate high sales to cover such costs. When they fail, they have to lose significant money.
Furthermore, operating leverage usually has implications for the intensity of competition among firms. Weakened market demand results in the high intensity of competition. Individual companies must maintain sales volume to cover high fixed costs.
Calculating operating leverage
To calculate the degree of operating leverage, you can use several approaches.
First, you can calculate it by comparing the percentage change of the operating profit to the sales percentage change. Operating profit equals revenue minus operating costs (fixed costs plus variable costs). In the income statement, operating cost items include the cost of goods sold, selling, general and administrative costs. Other authors might replace operating income with earnings before interest and taxes (EBIT).
Second, you can compare the total contribution with operating profit. The total contribution (or contribution margin) shows you how much sales can cover variable costs. To calculate this, you subtract total variable costs from revenue. The company uses the remaining amount to cover fixed costs and as a profit.
Third, you compare the total fixed costs to the total operating costs. This measure shows you how much the company’s operations are subject to fixed costs. The higher the fixed costs, the higher the operating leverage of the company.
As you can see, the operating leverage can be positive or negative. Positive leverage indicates the company is generating sales over total costs. Conversely, negative leverage indicates the company is not generating enough revenue to cover costs or when the contribution margin is less than the total fixed cost.
Take a simple example. A company sells 5,000 units of product, each for $14 per unit. The company incurs fixed costs of $4,000 and variable costs of $0.30 per unit to produce it.
Using the formula, you can calculate the company’s operating leverage as follows:
Operating Leverage = [5,000 x ($14 – $0.30)]/[5,000 x ($14 – $0.30) – $4,000] = 1.06
Difference between operating leverage and financial leverage
Operating leverage shows the proportion of fixed costs in the operating cost structure. Meanwhile, financial leverage measures the proportion of debt to the company’s capital structure.
Like a fixed cost, a company must pay debts, regardless of the business conditions. If it borrows from a bank, the company must pay regular installments. For debt securities, such as corporate bonds, it must pay regular coupons and principal at the end of maturity.
If it has a high proportion of debt, we say the company has high financial leverage. Companies need a high enough profit and revenue to pay back debts.
High leverage indicates that the company has high financial risk and default risk. The pressure on the company’s revenue increases as the business environment deteriorates, causing the company to make a few sales. Even if their revenue or profits fall, they must still pay debts and interest expenses.
If it is late in paying, the company will experience default. That can lead to bankruptcy, and legal proceedings can force the company to pay off debts or get a more manageable payment plan.
Several indicators are for measuring financial leverage. Here, I present some formulas:
How to use operating leverage in analysis
High leverage is not necessarily bad. Some industries tend to be highly leveraged because they are highly dependent on heavy and expensive equipment. Therefore, in the analysis, you must understand the nature of the company’s business. You have to compare the ratio with peers or the average companies in the same industry to get objective insights.
High or low leverage
High-operating-leverage companies are more vulnerable to selling risk. They must generate sufficient revenue to cover fixed costs. If they cannot do so, they must incur significant losses due to the high fixed costs.
Sales risk depends on the company’s strategy in generating sales and dealing with the external environment. Factors such as a deteriorating macroeconomic condition, falling market demand, or increasing competition can significantly pressure a company’s sales. Such conditions may force the company to offer discounts or lower prices to achieve sales targets.
Meanwhile, low operating leverage indicates that most operating costs are variable costs. Variable costs will only appear when there is a sale. When sales go down, they go down too. Likewise, when sales go up, so will they go up.
The company doesn’t have to generate a lot of sales volume to cover fixed costs. However, because variable costs are relatively significant, firms typically generate lower profit margins for each additional sale.
Operating leverage depends on the nature of the business.
In the analysis, you should compare the operating leverage with peers in the same industry. So, you can judge the high or low leverage of the company more objectively.
Leverage varies between companies, depending on the nature of the business and the industry in which they operate. Some industries have a higher proportion of fixed costs than others. For example, heavy industries have high operating leverage. Likewise, technology companies, utilities, and airlines usually have a significant fixed cost component. They rely on heavy equipment or expensive technology to produce output or provide services.
In contrast, consulting firms, restaurants, and some labor-intensive firms have low operating leverage. They are less dependent on fixed assets such as expensive heavy machinery and equipment. When sales fall, they incur lower costs. Variable costs will fall as sales decline, so do with total cost.