Operating Leverage
August 21, 2024
Operating leverage provides insight into how a company’s cost structure affects its profitability. It measures the proportion of fixed versus variable costs and how changes in sales volume impact operating income. Understanding operating leverage is crucial for business owners who want to optimize profitability and make informed financial decisions and analysts who must make robust forecasts of future profitability.
Key Learning Points
- Operating leverage measures a company’s ability to use fixed costs to increase profits as sales grow
- High operating leverage involves substantial fixed costs, significantly boosting profits once these costs are covered
- Operating leverage is quantified by the Degree of Operating Leverage (DOL), which measures the sensitivity of operating income to sales changes
- High operating leverage indicates potential for significant profit increases with sales growth but also higher risk during downturns
What is Operating Leverage?
Operating leverage refers to the degree to which a company can use fixed costs to generate greater profits as sales increase. Fixed costs do not vary with activity levels, while variable costs change directly according to activity levels. Companies with high operating leverage have a higher proportion of fixed costs in their total cost structure, which means beyond the breakeven volume, a small increase in sales can lead to a significant increase in operating income, which in turn will increase operating margin. In contrast, companies with low operating leverage rely more on variable costs, which means that any change in revenue will have a similar impact on operating profit, so their operating margin is less sensitive to changes in sales.
How Operating Leverage Works
To understand how operating leverage works, it’s essential to grasp the difference between fixed and variable costs:
Fixed Costs: These are expenses that do not change with the level of production or sales. So if a company sells 10% more product than the previous quarter, its fixed costs will be unchanged compared with the previous quarter.
Variable Costs: These costs vary directly with the level of production or sales. So if a company sells 10% more product than the previous quarter, its variable costs will also increase by 10% compared with the previous quarter.
While the exact details of fixed and variable costs can be determined through cost accounting, this information is typically not available in public disclosures. However, financial accounting offers close proxies: the cost of goods sold (COGS) is usually variable, while selling, general & administrative (SG&A) costs are generally fixed. Depreciation and amortization are also major fixed costs. These figures are readily available in annual and quarterly filings.
Now, let’s look at how operating leverage works: A company with high operating leverage incurs substantial fixed costs, meaning that once these costs are covered, any additional revenue contributes significantly to profit, provided variable cost as percentage to unit price is low. For instance, consider a manufacturing firm with high fixed costs due to machinery and plant operations. Once these fixed costs are covered by sales, additional revenue mostly goes toward profit, significantly boosting the bottom line.
How Operating Leverage is Calculated?
Operating leverage can be quantified and is also known as Degree of Operating Leverage (DOL). The DOL quantifies the sensitivity of a company’s operating income to changes in sales volume. It is a ratio that measures the percentage change in operating income for a given percentage change in sales.
Alternatively, DOL can be calculated as below:
Where the Contribution Margin is Revenue minus Variable Cost.
Sample illustration:
- Company A has a high proportion of fixed costs relative to variable costs, resulting in a DOL of 267%, which indicates high operating leverage.
- Company B has a low proportion of fixed costs relative to variable costs, resulting in a DOL of 133%, indicating low operating leverage.
What Does Operating Leverage Tell You?
Operating leverage helps assess the risk and potential profitability of a business. High operating leverage indicates that a company can significantly increase its profitability with sales growth, but it also implies higher risk during economic downturns. Investors and analysts use this information to evaluate a company’s risk profile and investment potential. Additionally, operating leverage is a highly effective tool to forecast company’s financials. It helps to understand the breakeven volume, and how the growth in revenue will be reflected in operating income and operating margins (refer Microsoft case study below).
High Operating Leverage Calculation Example
Companies with high operating leverage experience significant changes in operating income with changes in sales. This scenario is beneficial when sales are increasing, as profits grow rapidly. However, it also means higher risk during periods of declining sales, as fixed costs remain constant regardless of sales volume.
Case study: Microsoft, a leading technology company, operates through three reporting segments:
- Productivity and Business Processes
- Intelligent Cloud
- More Personal Computing
The ‘More Personal Computing’ segment includes:
- Windows, including Windows OEM licensing and other non-volume licensing of the Windows operating system
- Devices, including Surface and PC accessories
- Gaming, including Xbox hardware and Xbox content and services
- Search advertising
Between FY 2017 and FY 2021, Microsoft’s “More Personal Computing” segment consistently increased its operating margin from 22% to 36%, with its Degree of Operating Leverage (DOL) reaching as high as 432% in FY 2020.
Source: Felix
Insight: The products within the “More Personal Computing” segment, such as Windows and other software, involve high development costs but low variable costs. For instance, Microsoft makes significant investments in R&D to develop and enhance these products. These R&D costs are primarily fixed and do not fluctuate with the number of units sold. Once products like Windows or Office are developed, the cost of producing and distributing additional copies is minimal, resulting in very low variable costs. Consequently, each additional sale significantly boosts operating income. This cost structure is dominated by high fixed costs and minimal variable costs and leads to a high degree of operating leverage in this segment.
Low Operating Leverage Calculation Example
Companies with low operating leverage experience more stable operating income as sales fluctuate. They face lower risk during downturns but also have less potential for margin expansion during sales growth.
Case study: In Aug 2022, Accenture reported a 23% increase in its annual operating income compared to a 22% jump in its annual revenue. Similarly, in Aug 2021, it reported a 17% increase in annual operating income versus a 14% jump in annual revenue. This indicates that the change in operating income relative to revenue is not very dramatic, with Accenture’s DOL ranging between 1 and 1.2x. Additionally, the company has maintained a consistent operating margin of 15% from 2020 to 2022.
Source: Felix
Insight: The biggest asset in the consulting industry is its employees, who generate revenue on an hourly basis through client consultations. During an upcycle, when demand increases, consulting firms hire more employees to support additional consulting work. As revenue increases, expenses also rise proportionately, with most additional expenses directed towards employee compensation. Conversely, during a downcycle, when demand decreases, firms reduce their workforce. These companies aim to maintain a targeted operating margin and typically exhibit low operating leverage.
Use Case of Operating Leverage in Investment Banking
In investment banking, operating leverage is crucial for assessing a company’s risk and profitability, valuing businesses, and structuring deals. High operating leverage indicates greater profit potential during economic upswings but higher risk during downturns, and also affects discounted cash flow projections and comparative valuations. It’s vital in M&A due diligence to understand cost structures and synergies, and in debt structuring to advise on optimal capital structures and loan covenants. Additionally, operating leverage informs investment strategies and risk management, aiding in performance benchmarking and financial modeling to guide strategic planning and investment decisions.
Conclusion
Understanding operating leverage is crucial for assessing a company’s cost structure and potential profitability. High operating leverage can lead to significant profit increases with sales growth but also comes with higher risk during downturns. Conversely, low operating leverage provides stability but limits margin expansion potential. By analyzing operating leverage, businesses, investors, and analysts can make more informed decisions to optimize financial performance and manage risks effectively.