Operating Leverage Captures Relationships

By Ben McClure AAA

Return on equity, free cash flow (FCF) and price-to-earnings ratios are a few of the common methods used for gauging a company's well-being and risk level. One measure that doesn't get enough attention is operating leverage, which captures the relationship between a company's fixed and variable costs. (To read more on ratios, see Analyze Investments Quickly With Ratios and the Ratio Analysis Tutorial.)

In good times, operating leverage can supercharge profit growth. In bad times, it can crush profits. Even a rough idea of a firm's operating leverage can tell you a lot about a company's prospects. In this article, we'll give you a detailed guide to understanding operating leverage.

What Is Operating Leverage?
Essentially, operating leverage boils down to an analysis of fixed costs and variable costs. Operating leverage is highest in companies that have a high proportion of fixed operating costs in relation to variable operating costs. This kind of company uses more fixed assets in the operation of the company. Conversely, operating leverage is lowest in companies that have a low proportion of fixed operating costs in relation to variable operating costs. (To learn more about operating and financial leverage, read What are the risks of having both high operating leverage and high financial leverage?)

The benefits of high operating leverage can be immense. Companies with high operating leverage can make more money from each additional sale if they don't have to increase costs to produce more sales. The minute business picks up, fixed assets such as property, plant and equipment (PP&E), as well as existing workers, can do a whole lot more without adding additional costs. Profit margins expand and earnings soar faster than revenues. (Read more about margins in The Bottom Line On Margins and Measuring Company Efficiency.)

The best way to explain operating leverage is by way of examples. Take, for example, a software maker such as Microsoft. The bulk of this company's cost structure is fixed and limited to upfront development and marketing costs. Whether it sells one copy or 10 million copies of its latest Windows software, Microsoft's costs remain basically unchanged. So, once the company has sold enough copies to cover its fixed costs, every additional dollar of sales revenue drops into the bottom line. In other words, Microsoft possesses remarkably high operating leverage.

By contrast, a retailer, such as Wal-Mart demonstrates relatively low operating leverage. The company has fairly low levels of fixed costs, while its variable costs are large. Merchandise inventory represents Wal-Mart's biggest cost. For each product sale that Wal-Mart rings in, the company has to pay for the supply of that product. As a result, Wal-Mart's cost of goods sold (COGS) continues to rise as sales revenues rise.

Risky Business
Operating leverage can tell investors a lot about a company's risk profile and although high operating leverage can often benefit companies, companies with high operating leverage are also vulnerable to sharp economic and business cycle swings.

As stated above, in good times, high operating leverage can supercharge profit. But companies with a lot of costs tied up in machinery, plants, real estate and distribution networks can't easily cut expenses to adjust to a change in demand. So, if there is a downturn in the economy, earnings don't just fall, they can plummet.

Consider the software developer Inktomi. During the 1990s investors marveled at the nature of its software business. The company spent tens of millions of dollars to develop each of its digital delivery and storage software programs. But thanks to the internet, Inktomi's software could be distributed to customers at almost no cost. In other words, the company had close to zero cost of goods sold. After its fixed development costs were recovered, each additional sale was almost pure profit.

After the collapse of dotcom technology market demand in 2000, Inktomi suffered the dark side of operating leverage. As sales took a nosedive, profits swung dramatically to a staggering $58 million loss in Q1 of 2001 – plunging down from the $1 million profit the company had enjoyed in Q1 of 2000. The high leverage involved in counting on sales to repay fixed costs can put companies and their shareholders at risk. High operating leverage during a downturn can be an Achilles heel, putting pressure on profit margins and making a contraction in earnings unavoidable.

Indeed, companies such as Inktomi, with high operating leverage, typically have larger volatility in their operating earnings and share prices. As a result, investors need to treat these companies with caution. (To read more about the dotcom bust, see The Greatest Market Crashes and When Fear And Greed Take Over.)

Measuring Operating Leverage
Operating leverage occurs when a company has fixed costs that must be met regardless of sales volume. When the firm has fixed costs, the percentage change in profits due to changes in sales volume is greater than the percentage change in sales. With positive (i.e. greater than zero) fixed operating costs, a change of 1% in sales produces a change of greater than 1% in operating profit.

A measure of this leverage effect is referred to as the degree of operating leverage (DOL), which shows the extent to which operating profits change as sales volume changes. This indicates the expected response in profits if sales volumes change. Specifically, DOL is the percentage change in income (usually taken as earnings before interest and tax, or EBIT) divided by the percentage change in the level of sales output.

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For illustration, let's say a software company has invested $10 million into development and marketing for its latest application program, which sells for $45 per copy. Each copy costs the company $5 to sell. Sales volume reaches one million copies.

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So, the software company enjoys a DOL of 1.33. In other words, a 25% change in sales volume would produce a 1.33 x 25% = 33% change in operating profit.

Unfortunately, unless you are a company insider, it can be very difficult to acquire all of the information necessary to measure a company's DOL. Consider, for instance, fixed and variable costs, which are critical inputs for understanding operating leverage. It would be surprising if companies didn't have this kind of information on cost structure, but companies are not required to disclose such information in published accounts.

Investors can come up with a rough estimate of DOL by dividing the change in a company's operating profit by the change in its sales revenue.

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Looking back at a company's income statements, investors can calculate changes in operating profit and sales. Investors can use the change in EBIT divided by the change in sales revenue to estimate what the value of DOL might be for different levels of sales. This allows investors to estimate profitability under a range of scenarios.

Conclusion
Be very careful using either of these approaches. They can be misleading if applied indiscriminately. They do not consider a company's capacity for growing sales. Few investors really know whether a company can expand sales volume past a certain level without, say, sub-contracting to third-parties or further capital investment, which would increase fixed costs and alter operational leverage. At the same time, a company's prices, product mix and cost of inventory and raw materials are all subject to change. Without a good understanding of the company's inner workings, it is difficult to get a truly accurate measure of the DOL.

Nevertheless, it worth getting even a rough idea of a company's operating leverage. Even if it is not 100% accurate, knowledge of a company's DOL can help us assess the level of risk it offers to investors.

Although you need to be careful when looking at operating leverage, it can tell you a lot about a company and its future profitability. Investors can get a rough sense of the company's outlook and risk in the face of changing market conditions. While operating leverage doesn't tell the whole story, it certainly can help.

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