Operating Leverage Meaning

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Alternatively, Operating Leverage can be defined as the capability of the firm to use its fixed expenses to generate better returns. For example, the above graph notes that companies like Accenture, Cognizant, Automatic Data Processing, and Paychex have lower leverage (~1.0x). In contrast, companies like Delta Airlines, China Eastern Airlines, and National Grid have a higher Leverage.

Key Takeaways

  • Operating Leverage is the relation between a company’s operations and revenue from operations and the profitability that the company derives.Different types of costs are associated with Operating Leverage, such as – Fixed Costs, the costs that are fixed in nature and don’t depend on the sales. In contrast, the variable costs depend on the company’s operations, followed by the semi-fixed, semi-variable costs, which are variable or fixed in nature up to a limit, or a small percentage of the company’s production capacity. A lower operating leverage cost means more variable costs and reduced fixed costs, indicating that the company has to earn to break even. In comparison, a high operating leverage cost means more fixed costs and lower variable costs, indicating that the company already reaches break-even.

Why do some companies have higher operating leverage while others have lower leverage? What are the things we should be mindful of as financial analysts?

Understanding the Company’s Costs

As we all know, no product is manufactured free of cost by any organization. Finally, various costs are incurred to bring the product on the shelf, ready for the consumers to buy and consume. All these costs incurred can be bifurcated into two main categories – fixed costs and variable costs.

What are the fixed costs?

  • As the name suggests, these costs are fixed, and will not change irrespective of the number of units produced.E.g., the Rent of the factory, which an organization pays every month, will remain fixed irrespective of the fact that they produce 500 or 5,000 units of 5,00,000 units of the product.

What are the variable costs?

  • As opposed to fixed costs, variable costs vary with the number of units produced. In other words, they are directly proportionally with units produced.E.g., Raw materials consumed to produce the finished product. Say the company is in the business of assembling a mobile phone, and the battery is a raw material for the company. In this case, the cost of batteries consumed will be a variable cost for the company as the volume is dependent directly on the volume of the total production of mobile phones in a given period.

What are semi-variable / semi-fixed costs?

  • Apart from the fixed and variable costs, some costs are neither completely fixed nor completely variable.E.g., A Company promises its floor manager a salary of $ 1,000 + 2% of the cost price for every unit produced in a given month. In this case, $ 1,000 is a fixed cost that the company will have to pay even if there is no production. At the same time, 2% of the cost price paid is a variable cost, which will be in the case of no production.

Note: There is a thin line between fixed and variable costs differentiation. What is fixed for a given company, and a given situation may be variable for the same company for a different situation?

The best example is the workforce costs. The salary paid to an accountant is a fixed cost, whereas wages paid to the workers per product is a variable cost. So even though both are included as workforce costs in a company, they can still be bifurcated into fixed and variable.

How to Interpret Operating Leverage?

Operating leverage calculation measures the company’s fixed costs as a percentage of its total costs. Therefore, a company with a higher fixed cost will have high operating leverage than a higher variable cost.

Lower operating leverage –

  • This implies lower fixed costs and higher variable costs. In this case, a company has to achieve minimum sales, covering its fixed costs. Once it crosses the break-even point where all its fixed costs are covered, it can earn profit.Once it crosses the break-even point where all its fixed costs are covered, it can earn incremental profit in terms of Selling Price minus the Variable Cost, which will not be very substantial as the variable costs are high.When the operating leverage is low and fixed costs are lower, we can safely conclude that the break-even units a company needs to sell to suffer a no loss & no profit equation will be comparatively lower.

Higher operating leverage –

  • This implies lower variable costs and higher fixed costs. Here, as the fixed costs are higher, the break-even point will be higher.The company will have to sell the number of units to ensure no loss & no profit situation. On the other hand, the advantage here is that after the break-even is achieved, the company will earn a higher profit on every product as the variable cost is very low.

Companies generally prefer lower operating leverage so that even in cases where the market is slow, it would not be difficult for them to cover the fixed costs.

Related Topics – Income Statement InterpretationIncome Statement InterpretationThe income statement is one of the company’s financial reports that summarizes all of the company’s revenues and expenses over time in order to determine the company’s profit or loss and measure its business activity over time based on user requirements.read more, Profit MarginsProfit MarginsProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more

Operating Leverage Formula

It is the percentage change in operating profit relative to sales. It is also known as the “Degree of Operating Leverage or DOL.” Please note that the greater use of fixed costs, the greater the impact of a change in sales on a company’s operating income.

Formula = % change in EBIT / % change in Sales.

Let us take a simple example.

  • Sales 2015 = $500, EBIT 2015 = $200Sales 2014 = $400, EBIT 2014 = $150% change in EBIT = ($200-$150)/$150 = 33%% change in Sales = ($500-$400)/$400 = 25%Degree of Operating Leverage = 33/25 = 1.32x

This means that Operating profit changes by 2% for every 1% change in Sales.

Also, have a look at EBIT vs. EBITDA – Top differencesEBIT Vs. EBITDA - Top DifferencesEBIT signifies the operating profit the company makes before the inclusion of interest and tax expenses. In comparison, EBITDA determines the company’s overall operational profitability by summing the depreciation and amortization expenses to the operating profit.read more.

Calculate Operating Leverage of Colgate

  • Colgate’s DOL = % change in EBIT / % change in Sales.I have calculated the operating leverage ratio for each year from 2008 – to 2015.Colgate’s DOL is very volatile as it ranges from 1x to 5x (excluding the year 2009 where sales growth was almost 0%).It is expected that Colgate’s DOL will be higher as we note that Colgate has made significant investments in Property, plant, equipment and intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can’t touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. read more. These long-term assets account for more than 40% of the total assets.

DOL formula = % change in EBIT / % change in Sales

  • Higher Fixed CostsLower Variable Costs

Accenture Example

source: Accenture SEC Filings

DOL Formula = % change in EBIT / % change in Sales

DOL of Accenture – 2016

  • % change in EBIT (2016) = (4810,445 – 4,435,869)/4,435,869 = 8.4%% change in Sales (2016) = (34,797,661 – 32,914,424)/32,914,424 = 5.7%Accenture’s DOL (2016) = 8.4% / 5.7% = 1.5x

DOL of Accenture – 2015

  • % change in EBIT (2015) = (4,435,869 – 4,300,512 )/4,300,512 = 3.1%% change in Sales (2015) = (32,914,424 – 31,874,678)/31,874,678 = 3.3%Accenture’s DOL (2015) = 3.1% / 3.3% = 0.96x

Reasons for low DOL of Accenture

  • Lower Fixed CostsHigher Variable Costs. Such companies bill clients on a per-hour basis, and variable costs are in the form of developers’/consultant salaries.

IT Services Firm Example

Salient Features of IT Services Firm –

  • Lower Fixed CostsVariable Costs depend on the project and developer salaries.Operating Leverage should be relatively lower.

Below is the list of the Top IT Services firm and their DOL for the year of 2016-2017

source: ycharts

  • We did the example of Accenture earlier and found that its DOLs are 1.48x.Similarly, other IT Services Firm like Cognizant, Infosys, Gartner have DOLs closer to or less than 1.0x

Airline Sector Example

Salient features of the Airline Sector

  • Higher Fixed CostsLower Variable Costs (as compared to fixed costs)Due to the above, this sector should have high Leverages.

Below is the list of some of the Top Airline companies along with their DOLs for 2016-2017

Business Services Companies Example

Salient features of Business Services

  • Lower Fixed CostsHigher Variable CostsShould have lower DOL

Below is the list of Top Business Services Companies along with their 2016-17 Leverages

  • We note that overall the sector has an Operating Leverage of closer to 1.0xAutomatic Data Processing has a leverage of 1.31x, whereas, Leverage of Booz Allen Hamilton is 1.21x

Utility Companies Example

Salient features of Utilities Sector

  • Higher Fixed CostsLower Variable CostsThe overall sector should have a higher Leverage as compared to business services or IT Services

Below is the list of Top utility companies with their Market Cap along with 2016-2017 DOLs

  • Overall the sector has higher leverage than other low capital intensive sectorsCapital Intensive SectorsCapital intensive refers to those industries or companies that require significant upfront capital investments in machinery, plant & equipment to produce goods or services in high volumes and maintain higher levels of profit margins and return on investments. Examples include oil & gas, automobiles, real estate, metals & mining.read more. Most of the companies have operating leverage of more than 3.0xNational Grid has a DOL of 10.37x, whereas Sempra Energy has a DOL of 33.10x

Conclusion

While we analyze a company, we must look at its Operating Leverage ratio. DOL helps us evaluate how sensitive its operating income is concerning changes in Sales. Higher DOL will result in a bigger change in Operating income when sales increase. However, in the case of adverse situations of Sales decrease, such companies’ Operating Income will get hit the most. On the other hand, companies with Lower DOL will see only a proportional change in Operating IncomeOperating IncomeOperating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business. It doesn’t take into consideration non-operating gains or losses suffered by businesses, the impact of financial leverage, and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business.read more.

As an analyst, you should fully understand a company’s cost structureCost StructureCost Structure refers to those costs or expenses (fixed as well as variable costs) which businesses will incur or will have to incur to produce the desired objective of the business; such costs include the cost of purchasing the raw material to the cost of packaging the finished products.read more, fixed costs, variable costs, and operating leverage. This information is very helpful when you forecast financials and prepare its financial model in excelFinancial Model In ExcelFinancial modeling in Excel refers to a tool used for preparing the expected financial statements predicting the company’s financial performance in a future period using the assumptions and historical performance information.read more.

Frequently Asked Questions

Operating leverage is the primary indicator comparing a company’s fixed costs with the variable costs. Higher operating Leverage means the company has more fixed costs, which means the company utilizes fixed assets more efficiently and hence has a better chance of receiving more profits.

A company can improve operating Leverage through the acquisition of more fixed assets by the companies. It helps the company instigate more assets to support the core functioning, thus improving the operating Leverage.

The operating Leverage can be zero when the firm possesses no fixed assets. It will mathematically indicate that, in the company’s financials, the percentage change in EBIT will be the same as the percentage change in sales. Due to this, the operating Leverage is absent.

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