INTRODUCTION
Operating leverage is a powerful ally and a formidable challenge in the intricate world of business finance. The operating lever can catapult a company’s profits to new heights during times of growth—or send them plummeting when the tides turn. Whether you’re soaring through the skies with Delta Air Lines or navigating the bustling aisles of Walmart, understanding operating leverage is key to mastering the art of profitability. This concept holds the potential to amplify success, but it also demands careful management to avoid the pitfalls of economic downturns. Let’s explore how operating leverage plays out in real-life scenarios, revealing its impact on businesses with vastly different cost structures.
WHAT IS OPERATING LEVERAGE?
Operating leverage indicates how extensively a company relies on fixed costs in its operations. These fixed costs, such as rent, salaries, and depreciation, remain constant regardless of changes in production or sales levels. The higher the proportion of fixed costs in a company’s cost structure, the higher its operating leverage. Operating leverage essentially gauges how much a company’s operating income (EBIT) will fluctuate in response to changes in sales.
When a company has high operating leverage, a small increase in sales can lead to a much larger increase in operating income. This is because the fixed costs remain constant, so any additional revenue goes directly to covering those costs and then contributing to profits. Conversely, if sales decline, high operating leverage can cause a sharp drop in profits, making the company more vulnerable to downturns.
Understanding the Degree of Operating Leverage (DOL)
The degree of operating leverage (DOL) quantifies the relationship between sales and operating income. It indicates how operating income, measured as Earnings Before Interest and Taxes (EBIT), will vary in response to changes in sales. A higher DOL indicates that a company has higher fixed costs relative to variable costs, and thus greater potential for profit amplification (and risk) as sales change.
The formula to determine the degree of operating leverage is:
DOL = Percentage Change in EBIT
Percentage Change in Sales
Another way to express it is through the contribution margin:
DOL = Contribution Margin
EBIT
Where:
Contribution Margin = Sales Revenue – Variable Costs
EBIT = Earnings Before Interest and Taxes (i.e Sales Revenue- Variable cost- Fixed cost; excluding interest and taxes)
This formula shows how sensitive the operating income is to a percentage change in sales. The higher the DOL, the greater the impact of sales fluctuations on operating income.
Calculating Operating Leverage: A Practical Example
Let’s explore how operating leverage works with a practical example. Imagine a company, ABC Manufacturing, that produces and sells widgets. The company has fixed costs of $100,000 per year and variable costs of $10 per widget. Each widget sells for $30.
If the company sells 10,000 widgets:
| Particulars | Working | Amount |
| Units Sold | 10000 | |
| Sales Revenue (A) | =10000*30 | $ 3,00,000 |
| Variable Cost (B) | =10000*10 | $ 1,00,000 |
| Contribution Margin (A-B) | $ 2,00,000 | |
| Fixed Cost | $ 1,00,000 | |
| EBIT (Contribution Margin -Fixed Cost) | $ 1,00,000 |
Now, suppose sales increase by 10% to 11,000 widgets:
| Particulars | Working | Amount |
| Units Sold (10000*110%) | 11000 | |
| Sales Revenue (A) | =11000*30 | $ 3,30,000 |
| Variable Cost (B) | =11000*10 | $ 1,10,000 |
| Contribution Margin (A-B) | $ 2,20,000 | |
| Fixed Cost | $ 1,00,000 | |
| EBIT (Contribution Margin -Fixed Cost) | $ 1,20,000 |
Calculation by Formula 1
The percentage change in EBIT = (1,20,000-1,00,000)/1,00,000= 20%
The percentage change in Sales = (3,30,000-3,00,000)/3,00,000= 10%
Hence DOL= Percentage change in EBIT/ Percentage change in Sales Revenue
= 20%/10%
= 2
Calculation by Formula 2
Percentage of Contribution by Sales= (200,000/300,000*100)=66.66%
Percentage of EBIT by Sales= (100,000/300,000*100)=33.33%
Hence DOL= Percentage of Contribution by Sales/ Percentage of EBIT by Sales
= 66.66%/33.33%
= 2
This DOL of 2 indicates that a 10% increase in sales results in a 20% increase in EBIT, showcasing how operating leverage amplifies profits.
THE STRATEGIC USE OF OPERATING LEVERAGE: INSIGHTS FROM THE AIRLINE AND RETAIL INDUSTRIES
Operating leverage can serve as a powerful tool for amplifying profits or a risky factor that magnifies losses, depending on how it’s managed. The impact of operating leverage is particularly significant in industries with different cost structures, such as airlines and retail.
High Operating Leverage: Delta Airlines Example
Consider a major U.S. airline like Delta Air Lines. Airlines typically operate with high operating leverage due to the significant fixed costs associated with owning and maintaining a fleet of aircraft, leasing airport gates, and paying for labor and fuel. These costs remain largely the same regardless of the number of passengers or flights.
During periods of high demand, such as peak travel seasons, Delta benefits from its high operating leverage. As more passengers book flights, the revenue from ticket sales increases, but the fixed costs do not rise proportionally. This means that most of the additional revenue contributes directly to the airline’s profits, leading to a sharp increase in operating income.
However, during downturns, such as economic recessions or unexpected events like the COVID-19 pandemic, the risks of high operating leverage become apparent. If demand for air travel drops, Delta still incurs the same high fixed costs, but with lower revenue, the company’s operating income can plummet. This was evident during the pandemic when airlines experienced significant financial losses due to a steep decline in passenger numbers.
Low Operating Leverage: Walmart Example
On the other hand, consider Walmart, a leading U.S. retailer. Unlike ExxonMobil, Walmart operates with lower operating leverage because a significant portion of its costs are variable. These costs include purchasing inventory and labor expenses, which can be adjusted based on sales volume and store activity.
During periods of increased sales, such as the holiday season, Walmart’s revenue rises. However, the increase in operating income is more moderate compared to a company like ExxonMobil with high operating leverage. This is because Walmart’s variable costs, such as buying more inventory and hiring additional staff, also increase as sales grow.
The advantage of Walmart’s low operating leverage becomes more evident during economic downturns. If consumer spending slows down, Walmart can protect its profitability by reducing inventory orders, scaling back on staffing, or cutting other variable expenses. This flexibility makes Walmart less vulnerable to a drop in sales, ensuring that its operating income does not suffer disproportionately when revenue declines.
The contrast between Delta Airlines and Walmart highlights the strategic implications of operating leverage. Delta Airlines’ high operating leverage allows it to capitalize on favorable market conditions but also exposes it to greater risk during downturns. In contrast, Walmart’s lower operating leverage offers more stability, enabling the company to adapt more readily to changes in sales. Understanding and managing operating leverage is essential for businesses across all industries to enhance financial performance and minimize risks.
HOW DOES OPERATING LEVERAGE IMPACT BREAK-EVEN ANALYSIS?
Operating leverage plays a crucial role in break-even analysis, a financial tool that helps businesses determine the level of sales needed to cover all costs, both fixed and variable. The interplay between operating leverage and break-even analysis provides insights into a company’s cost structure and its ability to achieve profitability.
Understanding Break-Even Analysis
Break-even analysis identifies the point where total revenue matches total costs, meaning the business neither makes a profit nor incurs a loss. The formula to find the break-even point (BEP) in units is:
Break-Even Point (Units) = Fixed Costs/ (Price per Unit −Variable Cost per Unit)
Impact of Operating Leverage on Break-Even Point
Operating leverage measures the proportion of fixed costs in a company’s total cost structure. A company with high operating leverage has a greater share of fixed costs compared to variable costs, whereas a company with low operating leverage has a larger proportion of variable costs.
High Operating Leverage: Companies with high operating leverage (like those in capital-intensive industries) have high fixed costs and low variable costs. This means that the contribution margin (the difference between sales revenue and variable costs) is higher, but the break-even point is also higher. These companies need to generate more sales to cover their fixed costs. However, once the break-even point is reached, additional sales lead to a rapid increase in profits because the fixed costs are already covered.
Low Operating Leverage: Companies with low operating leverage (like those in retail) have lower fixed costs and higher variable costs. This results in a lower break-even point, meaning they can achieve profitability at a lower level of sales. However, the profit margins are generally thinner after the break-even point is reached, as each additional unit sold still incurs significant variable costs.
Example
Consider two companies, A and B each selling 30000 units of product. Let’s see the DOL calculation for both the companies.
| Company A | Company B | |
| Particulars | ||
| Units Sold | 30000 | 30000 |
| Sales Revenue (A) | =30000*30=900,000 | =30*30000=900,000 |
| Variable Cost (B) | =30000*10=300,000 | =30000*20=600,000 |
| Contribution Margin (A-B) | 600000 | 300000 |
| Fixed Cost | 500000 | 100000 |
| EBIT (Contribution Margin -Fixed Cost) | 100000 | 200000 |
| Degree Of Leverage (Contribution Margin / EBIT) | 6 | 1.5 |
We can see from above that company A has high operating leverage as compared to company B.
| High Operating Leverage | Low Operating Leverage | |
| Particulars | Company A | Company B |
| Fixed Cost | 500000 | 100000 |
| Selling Price per unit | 30 | 30 |
| Variable cost per unit | 10 | 20 |
| Break Even Point | =500000/(30-10) | =100000/(30-20) |
| 25000 units | 10000 units |
Company A needs to sell 25,000 units to break even, while Company B only needs to sell 10,000 units. However, after reaching their respective break-even points, Company A will see a greater increase in profit for each additional unit sold, as its variable costs are lower.
HOW DOES CYCLICALITY INFLUENCE THE POWER OF OPERATING LEVERAGE?
Cyclical industries, like luxury automobiles, thrive during economic booms and struggle during downturns due to fluctuating demand. In these sectors, operating leverage—where high fixed costs dominate—can be both a boon and a burden. During prosperous times, companies see profits soar as rising sales directly boost the bottom line with little added cost. However, when the economy slows, those same fixed costs become a heavy anchor, dragging profits down sharply as revenues dwindle. This dual-edged nature of operating leverage in cyclical industries makes managing economic ups and downs a critical challenge.
WHY IS THE OPERATING LEVERAGE EQUATION IMPORTANT?
The operating leverage equation is essential because it provides a clear understanding of how a company’s fixed and variable costs affect profitability as sales volumes change. Here’s why it’s important:
- Profit Forecasting: It enables companies to predict how changes in sales will amplify or diminish profits, allowing for more accurate financial planning and budgeting.
- Risk Assessment: Companies with high operating leverage are more sensitive to sales fluctuations, leading to significant profit swings. Understanding this helps businesses assess and manage risk, especially in cyclical industries.
- Cost Structure Analysis: The equation sheds light on the balance between fixed and variable costs, guiding management in deciding whether to invest in fixed assets or maintain operational flexibility with more variable costs.
- Strategic Decision-Making: By knowing their operating leverage, companies can make informed decisions on pricing, production, and expansion, aligning strategies with financial goals.
- Pricing Strategy: The equation is vital in setting the sale price of products or services. Understanding operating leverage helps businesses determine how much they need to charge to cover fixed costs and achieve desired profit margins, ensuring pricing strategies are both competitive and profitable.
CONCLUSION
Operating leverage is a potent financial tool that can significantly impact a company’s profitability and risk exposure. By understanding and managing operating leverage, businesses can optimize their cost structures, enhance profitability, and better navigate economic fluctuations. For companies with high fixed costs, maintaining a keen awareness of operating leverage is essential to sustaining long-term financial health.
Whether you’re managing an airline company like Delta or retail major like Walmart or running a smaller enterprise, grasping the dynamics of operating leverage can provide a competitive edge in today’s fast-paced business environment.
