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Operating leverage
We saw that financial leverage uses debt to magnify shareholders' return on equity for a business: As the debt-equity ratio increases, return on equity increases for higher sales and profits.
We also saw that financial leverage is a two-edged sword: If sales and profits decline, return on equity drops sharply.
Like financial leverage, operating leverage magnifies the financial performance of a business. Instead of depending on the capital structure of the firm, however, operating leverage depends on its cost structure.
Cost structure of your business is based on the composition of fixed costs and variable costs. Fixed costs are those costs that don't change for different levels of output and sales. Rent and expenses for previously bought equipment are two types of fixed costs. In general, the fixed assets of your firm represent its fixed costs.
Variable costs are those costs that change for different levels of output and sales. Most obvious categories of variable costs are materials and labor related to the manufacture of goods. Together, these costs represent your cost of goods sold. Some discretionary expenses such as advertising, travel and employee perks are treated as variable costs.
To some degree, your business may treat payroll as a variable cost. However, a certain number of employees are necessary to maintain the efficiency of running your business. Small-business owners tend to have few excess workers, which leads them to treat payroll costs as a fixed cost.
If your business has a cost structure that leans towards higher fixed costs— say 70 to 80 percent of total costs—your break-even point comes at a higher level of production and sales. If your business has a cost structure that leans towards lower fixed costs as a percentage of total costs, your break-even point comes at a lower level of production and sales.
Exhibit A, below, shows a 12-month income statement for three levels of fixed costs: $50,000, $75,000, and $100,000. Variable costs are constant at 40% of net sales:
| Fixed costs (Exhibit A) |
$50,000 |
$75,000 |
$100,000 |
| Net sales |
$150,000 |
$150,000 |
$150,000 |
| Expenses: |
-- |
-- |
-- |
| Fixed costs |
$50,000 |
$75,000 |
$100,000 |
| Variable costs |
$60,000 |
$60,000 |
$60,000 |
| Total costs |
$110,000 |
$135,000 |
$160,00 |
| Pretax income |
$40,000 |
$15,000 |
($10,000) |
| Income tax (40%) |
$16,000 |
$6,000 |
($4,000) |
| Net income |
$24,000 |
$9,000 |
($6,000) |
| Net margin |
16.0% |
6.0% |
(4.0%) |
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Now let's take at look at an increase in sales. Exhibit B shows net profit and degree of operating leverage (DOL) when sales increase $50,000 to $200,000. The company maintains the same level of fixed costs. Variable costs remain constant at 40% of sales:
| Fixed costs (Exhibit B) |
$50,000 |
$75,000 |
$100,000 |
| Net sales |
$200,000 |
$200,000 |
$200,000 |
| Expenses: |
-- |
-- |
-- |
| Fixed costs |
$50,000 |
$75,000 |
$100,000 |
| Variable costs |
$80,000 |
$80,000 |
$80,000 |
| Total costs |
$130,000 |
$155,000 |
$180,00 |
| Pretax income |
$70,000 |
$45,000 |
$20,000 |
| Income tax (40%) |
$28,000 |
$18,000 |
$8,000 |
| Net income |
$42,000 |
$27,000 |
$12,000 |
| Net margin |
21.0% |
13.5% |
6.0% |
| DOL |
1.7 |
2.7 |
6.0 |
|
Exhibit B shows that the degree of operating leverage increases as fixed costs are higher and sales increase. With a $50,000 increase in sales to $200,000, DOL increases from 1.7 times to 6.0 times as fixed costs double to $100,000. In other words, the percentage increase in net income is much higher than the percentage increase in sales.
Finally, Exhibit C shows how operating leverage works to the disadvantage of your business. Specifically, when sales decrease, your net income falls at a much faster rate.
| Fixed costs (Exhibit C) |
$50,000 |
$75,000 |
$100,000 |
| Net sales |
$125,000 |
$125,000 |
$125,000 |
| Expenses: |
-- |
-- |
-- |
| Fixed costs |
$50,000 |
$75,000 |
$100,000 |
| Variable costs |
$50,000 |
$50,000 |
$50,000 |
| Total costs |
$100,000 |
$125,000 |
$150,00 |
| Pretax income |
$25,000 |
$0 |
($25,000) |
| Income tax (40%) |
$10,000 |
$0 |
($10,000) |
| Net income |
$15,000 |
$0 |
($15,000) |
| Net margin |
12.0% |
0% |
(12%) |
| DOL |
3.0 |
0.0 |
(3.0) |
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Exhibit C shows that the degree of operating leverage decreases as fixed costs are higher and sales decrease. With a $25,000 decrease in sales to $125,000, DOL increases from 3.0 times to negative 3.0 times as fixed costs increase to $100,000. (At fixed costs of $75,000, the firm breaks even. Since there is no net profit or loss, the DOL cannot be calculated.)
Understanding operating leverage is important because it too, like financial leverage, is a two-edged sword. When sales are increasing, a cost structure that favors fixed costs results in a greater percentage increase in profits. When sales slump, a high fixed-cost structure eats up profits.
Since your decisions on how to finance a business are based, in part, on how much in fixed assets you invest in, you will want to evaluate the role of operating leverage. You should avoid over-borrowing to pay for equipment and fixed assets that may result in a cost structure that penalizes you in a business or economic downturn.
Next Topic: Leasing versus buying
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