Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. In terms of units, we went from 2900 to 3480, an increase of 580 units, which is 20%. Increasing leverage through issuing more debt is an formula for operating leverage alternative to issuing equity.
Companies with a high degree of operating leverage (DOL) have a greater proportion of fixed costs that remain relatively unchanged under different production volumes. Most of a company’s costs are fixed costs that recur each month, such as rent, regardless of sales volume. As long as a business earns a substantial profit on each sale and sustains adequate sales volume, fixed costs are covered, and profits are earned. In fact, operating leverage occurs when a firm has fixed costs that need to be met regardless of the change in sales volume. This ratio summarizes the effects of combining financial and operating leverage, and what effect this combination, or variations of this combination, has on the corporation’s earnings. Not all corporations use both operating and financial leverage, but this formula can be used if they do.
Understanding operating leverage is crucial for business owners who want to optimize profitability and make informed financial decisions and analysts who must make robust forecasts of future profitability. A high degree of operating leverage provides an indication that the company has a high proportion of fixed operating costs compared to its variable operating costs. It also means that the company can make more money from each additional sale while keeping its fixed costs intact. As a result, fixed assets, such as property, plant, and equipment, acquire a higher value without incurring higher costs.
Many small businesses have this type of cost structure, and it is defined as the change in earnings for a given change in sales. The degree of operating leverage can show you the impact of operating leverage on the firm’s earnings before interest and taxes (EBIT). Also, the DOL is important if you want to assess the effect of fixed costs and variable costs of the core operations of your business. A higher operating leverage means the company has higher fixed costs, and a lower operating leverage means the company has higher variable costs. After its breakeven point, a company with higher operating leverage will have a larger increase to its operating income per dollar of sale. Other company costs are variable costs that are only incurred when sales occur.
High operating leverage indicates that a company can significantly increase its profitability with sales growth, but it also implies higher risk during economic downturns. Investors and analysts use this information to evaluate a company’s risk profile and investment potential. Additionally, operating leverage is a highly effective tool to forecast company’s financials. It helps to understand the breakeven volume, and how the growth in revenue will be reflected in operating income and operating margins (refer Microsoft case study below). Operating Leverage is a financial ratio that measures the lift or drag on earnings that are brought about by changes in volume, which impacts fixed costs.
This means that for a 10% increase in revenue, there was a corresponding 7.42% decrease in operating income (10% x -0.742). Variable costs decreased from $20mm to $13mm, in-line with the decline in revenue, yet the impact it has on the operating margin is minimal relative to the largest fixed cost outflow (the $100mm). From Year 1 to Year 5, the operating margin of our example company fell from 40.0% to a mere 13.8%, which is attributable to $100 million fixed costs per year. Most of Microsoft’s costs are fixed, such as expenses for upfront development and marketing. With each dollar in sales earned beyond the break-even point, the company makes a profit, but Microsoft has high operating leverage.
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%. 11 Financial may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. 11 Financial’s website is limited to the dissemination of general information pertaining to its advisory services, together with access to additional investment-related information, publications, and links. To say that a firm is “highly leveraged” means that it has considerably more debt than equity.
Retailers are among those with lower fixed costs vs. their much higher variable costs (merchandise is pretty variable). On the other hand, if the case toggle is flipped to the “Downside” selection, revenue declines by 10% each year, and we can see just how impactful the fixed cost structure can be on a company’s margins. The DOL is calculated by dividing the contribution margin by the operating margin. For example, the DOL in Year 2 comes out 2.3x after dividing 22.5% (the change in operating income from Year 1 to Year 2) by 10.0% (the change in revenue from Year 1 to Year 2). Now, we are ready to calculate the contribution margin, which is the $250mm in total revenue minus the $25mm in variable costs. The direct cost of manufacturing one unit of that product was $2.50, which we’ll multiply by the number of units sold, as we did for revenue.
Operating leverage can be quantified and is also known as Degree of Operating Leverage (DOL). The DOL quantifies the sensitivity of a company’s operating income to changes in sales volume. It is a ratio that measures the percentage change in operating income for a given percentage change in sales. 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. 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.
A firm with a relatively high level of combined leverage is seen as riskier than a firm with less combined leverage because high leverage means more fixed costs to the firm. But once that point is reached, every additional dollar in revenue has the potential to generate more profit because fixed costs stay the same, regardless of changes in production (volume). John’s Software is a leading software business, which mostly incurs fixed costs for upfront development and marketing. John’s fixed costs are $780,000, which goes towards developers’ salaries and the cost per unit is $0.08.
Fixed costs are costs that will be incurred whether or not a unit is produced, such as rent on a building, and variable costs are costs directly tied to the production of a unit, such as the raw material to produce a product. For instance, a business may promise a plant supervisor a weekly salary of $1,500, plus 1% of the cost price for every widget produced under that manager’s supervision. Given the points above, the operating leverage metric is MOST meaningful when you calculate it for companies in the same industry with roughly the same operating margins (i.e., the comparable companies). However, most companies do not explicitly spell out their fixed vs. variable costs, so in practice, this formula may not be realistic. Managers need to monitor DOL to adjust the firm’s pricing structure towards higher sales volumes as a small decrease in sales can lead to a dramatic decrease in profits.
Analyzing operating leverage helps managers assess the impact of changes in sales on the level of operating profits (EBIT) of the enterprise. Higher DOL means higher operating profits (positive DOL), and negative DOL means operating loss. One important point to be noted is that if the company is operating at the break-even level (i.e., the contribution is equal to the fixed costs and EBIT is zero), then defining DOL becomes difficult. So you, as a manager, just got word that one of your best selling products has new competition. Well, if you remember from our cost-volume-profit analysis, it isn’t a dollar for dollar change.
These industries have higher raw material costs and lower comparative fixed costs. For example, for a retailer to sell more shirts, it must first purchase more inventory. The cost of goods sold for each individual sale is higher in proportion to the total sale. For these industries, an extra sale beyond the breakeven point will not add to its operating income as quickly as those in the high operating leverage industry.