Operating Leverage
Just as financial leverage measures the use of fixed interest expense charged on debt financing to generate greater returns for equity investors, operating leverage measures the use of fixed operating costs to generate greater operating profit.
Operating leverage refers to the fact that, for a given level of fixed expenses, a given percentage change in sales will result in a higher percentage of change in earnings before interest and taxes (EBIT) . Even though in the long run all costs are variable, within the relevant range of activity some costs are not affected by changes in production volume or sales volume. Costs that do not vary within the relevant range of activity are called fixed costs or fixed expenses. Because fixed costs do not vary as volume changes, a change in sales volume causes a more than proportional change in EBIT.
A higher proportion of fixed expenses in total operating expenses results in higher operating leverage.
Until a company’s contribution margin (sales minus all variable expenses) is adequate to cover its fixed expenses, the company will operate unprofitably. Once fixed expenses are covered, though, increases in the contribution margin caused by increases in sales flow straight to the bottom line, as long as the fixed expenses do not change. The existence of the fixed costs magnifies the effect of increased sales on EBIT.
A company that has invested heavily in automated production equipment is an example of a company with high operating leverage. The company will have high fixed costs for the equipment. At the same time, it will have low variable costs. Labor is a variable cost of production, and the company with automated production equipment will have less need for labor and thus lower variable costs than would a company with labor-intensive production processes. In order for the high operating leverage to be successful, however, the company must earn a contribution margin that is high enough to cover the high fixed costs. Once the contribution margin has covered the fixed costs, though, increases in the contribution margin as a result of increased sales go straight to increase EBIT. The necessity to earn a contribution margin high enough to cover the fixed costs creates business risk for the company, but along with the increased business risk, the company receives the potential of higher rewards.
Business risk ⇒ refers to the risk of variability in earnings. Business risk is caused by variability of demand for the company’s products or services, variability in the company’s selling prices, variability of the price of inputs to the product, and the changes to the firm’s degree of operating leverage.
When a company is performing near its breakeven point (where profits are $0), the company will have greater changes in EBIT relative to changes in sales than it will when it is operating above or below its breakeven point. At sales levels above and below the breakeven point, the magnification effect will still be present, but it will not be quite as pronounced as it will be near the breakeven point.
When comparing two or more companies’ operating results, the company with a higher proportion of fixed costs in its cost structure will have higher operating leverage (all other things being equal). For the company with higher operating leverage, small changes in sales will lead to larger changes in EBIT, both positive and negative. If the company’s sales increase, EBIT will increase relatively more than the sales increase. If sales decrease, EBIT will decline relatively more than the sales decrease.
Look back at the formulas for DOL and DFL and convince yourself that if there are no fixed costs, DOL is equal to one, and that if there are no interest costs, DFL is equal to one. Values of one mean no leverage. No fixed costs, no operating leverage. No interest costs, no financial leverage. This should help tie these formulas to the concepts and help you know when you have the formulas right (or wrong). If you plug in zero for fixed costs, DOL should be one, and if you plug in zero for interest, DFL should be one.