What is Operating Leverage?
The Operating Leverage measures the proportion of a company’s cost structure that consists of fixed costs rather than variable costs.
If the composition of a company’s cost structure is mostly fixed costs (FC) relative to variable costs (VC), the business model of the company is implied to possess a higher degree of operating leverage (DOL).
Table of Contents
- How to Calculate Operating Leverage
- Operating Leverage Formula
- How Does Operating Leverage Impact Break-Even Analysis?
- How to Interpret Operating Leverage by Industry
- How Does Cyclicality Impact Operating Leverage?
- How to Analyze Operating Leverage
- Operating Leverage Calculator
- 1. High Operating Leverage Calculation Example
- 2. Low Operating Leverage Calculation Example
- 3. Operating Leverage Analysis Example
How to Calculate Operating Leverage
Companies with a high degree of operating leverage (DOL) have a greater proportion of fixed costs that remain relatively unchanged under different production volumes.
In contrast, companies with low operating leverage have cost structures comprised of comparatively more variable costs that are directly tied to production volume.
- Fixed Costs (FC) ➝ Fixed costs can be thought of as costs that are incurred and need to be paid out irrespective of the sales performance and production volume of a company. As a result, fixed costs tend to remain relatively constant. For example, rent for office space would be considered a fixed cost because the amount due each month is based on a contractual agreement – and thus, the rental cost is constant and independent of sales volume.
- Variable Costs (VC) ➝ Conversely, variable costs are directly tied to a company’s sales, meaning that such costs fluctuate based on sales performance in the given period. An example of variable costs is the delivery/shipping fee associated with the sale of products. The higher the volume of products produced and purchased by customers, the more delivery/shipping fees incurred by the company (and vice versa).
The reason operating leverage is an essential metric to track is because the relationship between fixed and variable costs can significantly influence a company’s scalability and profitability.
As a company generates revenue, operating leverage is among the most influential factors that determine how much of that incremental revenue actually trickles down to operating income (i.e. profit).
The more fixed costs there are, the more sales a company must generate in order to reach its break-even point, which is when a company’s revenue is equivalent to the sum of its total costs.
Operating Leverage Formula
Intuitively, the degree of operating leverage (DOL) represents the risk faced by a company as a result of its percentage split between fixed and variable costs.
In practice, the formula most often used to calculate operating leverage tends to be dividing the change in operating income by the change in revenue.
On that note, the formula is thereby measuring the sensitivity of a company’s operating income based on the change in revenue (“top-line”).
For both the numerator and denominator, the “change”—i.e., the delta symbol—refers to the year-over-year change (YoY) and can be calculated by dividing the current year balance by the prior year balance and then subtracting by 1.
Suppose the operating income (EBIT) of a company grew from 10k to 15k (50% increase) and revenue grew from 20k to 25k (25% increase).
The DOL would be 2.0x, which implies that if revenue were to increase by 5.0%, operating income is anticipated to increase by 10.0%.
Or, if revenue fell by 10%, then that would result in a 20.0% decrease in operating income.
A second approach to calculating DOL involves dividing the % contribution margin by the % operating margin.
Where:
- Contribution Margin (%) = (Revenue – Variable Costs) ÷ Revenue
- Operating Margin (%) = (Revenue – Variable Costs – Fixed Costs) ÷ Revenue
The contribution margin represents the percentage of revenue remaining after deducting just the variable costs, while the operating margin is the percentage of revenue left after subtracting out both variable and fixed costs.
However, companies rarely disclose an in-depth breakdown of their variable and fixed costs, which makes usage of this formula less feasible unless confidential internal company data is accessible.
How Does Operating Leverage Impact Break-Even Analysis?
Companies with higher leverage possess a greater risk of producing insufficient profits since the break-even point is positioned higher.
If a company has high operating leverage, each additional dollar of revenue can potentially be brought in at higher profits after the break-even point has been exceeded.
Therefore, each marginal unit is sold at a lesser cost, creating the potential for greater profitability since fixed costs such as rent and utilities remain the same regardless of output.
If a company has low operating leverage (i.e., greater variable costs), each additional dollar of revenue can potentially generate less profit as costs increase in proportion to the increased revenue.
The more revenue is produced, the more growth in the variable costs offsets the additional revenue and limits the company’s capacity to endure periods of lackluster sales performance (i.e., sustain its profit margins to stay in line with historical levels).
- Fixed Costs (FC)➝ Fixed costs remain the same irrespective of production volume, e.g. rent, warehousing, insurance, and spending on equipment (PP&E)
- Variable Costs (VC) ➝ Variable costs fluctuate and are directly tied to the volume of output, e.g. inventory purchases, sales commissions, shipping fees, delivery fees
When a company’s revenue increases, having a high degree of leverage tends to be beneficial to its profit margins and FCFs.
However, if revenue declines, the leverage can end up being detrimental to the margins of the company because the company is restricted in its ability to implement potential cost-cutting measures.
How to Interpret Operating Leverage by Industry
Common examples of industries recognized for their high and low degree of operating leverage (DOL) are described in the chart below.
High Operating Leverage Industry Examples | Low Operating Leverage Industry Examples |
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One notable commonality among high DOL industries is that to get the business started, a large upfront payment (or initial investment) is required.
For instance, a pharmaceutical drug manufacturer must spend significant amounts of capital to even get a drug designed and have a chance of receiving approval from the FDA, which is a very costly and time-consuming process.
Hence, less established pharmaceutical companies are often forced to increase the pricing of their drugs to just break even and cover these costs, which is typically met with much criticism from the general public (i.e., accusations of “price gouging” in pharma).
The shared characteristic of low DOL industries is that spending is tied to demand, and there are more potential cost-cutting opportunities.
For example, a clothing retailer must spend a decent amount of capital to get started and begin operating in terms of finding a physical location and purchasing the initial inventory to sell to customers at its store, but the required investment is marginal relative to an airline’s spending needs (e.g., purchasing aircraft, fuel, continuous maintenance).
Furthermore, another important distinction lies in how the vast majority of a clothing retailer’s future costs are unrelated to the foundational expenditures the business was founded upon.
- Telecom ➝ Network Infrastructure
- Airlines ➝ Aircraft Fleet (Aviation)
- Pharmaceutical ➝ Approved Drugs Available in the Market
But rather, the clothing retailer’s expenses going forward will mostly be related to:
- Inventory Orders (Continually Replenished)
- Employee Compensation/Payroll (Constant Hiring, Schedules on “As-Needed” Basis)
These two costs are conditional on past demand volume patterns (and future expectations). Since both the number of employees hired (and the number of hours worked), as well as the volume of inventory purchased, are “adjustable” factors, this provides the retailer a significant “cushion” in being able to reduce costs if deemed necessary.
How Does Cyclicality Impact Operating Leverage?
The catch behind having a higher DOL is that for the company to receive positive benefits, its revenue must be recurring and non-cyclical.
- Non-Cyclical Industries ➝ If a company operates in a non-cyclical industry, its sales are much more consistent and stable across different economic cycles (and far less sensitive to external market factors, such as commodity prices).
- Cyclical Industries ➝ For a company that operates in a cyclical industry, its sales tend to deviate to a much larger degree based on current economic conditions and are influenced by external, often unpredictable factors
If sales and customer demand turned out lower than anticipated, a high DOL company could end up in financial ruin over the long run. As a result, companies with high DOL and in a cyclical industry are required to hold more cash on hand in anticipation of a potential shortfall in liquidity.
For this reason, many private equity firms attempt to acquire companies with high DOL for the scalability benefits, but due to the use of significant leverage (i.e., debt financing) to fund the purchase, private equity firms will usually avoid cyclical companies.
A company with a high DOL coupled with a large amount of debt in its capital structure and cyclical sales could result in a disastrous outcome if the economy were to enter a recessionary environment.