Operating Leverage – A Key Parameter to Track when Investing

Published by Sharekhan Education | November 4, 2020

Operating Leverage – A Key Parameter to Track when Investing

Operating leverage is a concept related to the profit and loss statement. Typically most of the firms have two types of costs of operations. One is the variable cost, and the other is the fixed cost. A variable cost is a cost that usually changes with the changes in sales. For example, an increase in the volume of production increases the cost of goods sold needed to manufacture finished goods. It decreases with a decrease in the volume of production. On the other hand, a change in fixed cost is not correlated to a change in the volume of production. For example, rent, electricity, general & admin cost tends to change at a significantly lower rate, regardless of the volume of production. Hence a rise or fall in the volume of production will not impact these costs significantly. Therefore, companies with high fixed-cost tend to reduce their per-unit cost-of-production with an increase in sales volume.

Operating leverage is the degree to which a company can increase its operating profit by increasing its sales.

To understand this concept, let us look at the formula of the degree of operating leverage.

Degree of operating leverage = (Contribution margin / Profit) X 100 = Q X (Sales price per unit – Variable cost per unit) / [{Q X (Sales price per unit – Variable cost per unit)} – Fixed Cost] X 100

Let us take the example of a company with a high fixed cost and low variable cost. Say the company ‘A’ sells 100,000 units of a product at the price of Rs. 10. The company has a variable cost per unit of Rs. 2. Its fixed cost is Rs. 500,000.

Degree of operating leverage = 100,000 X (10-2) / [{100,000 (10-2)} – 500,000] X 100

= 800,000/[800,000-500,000] X 100

800,000/300,000 X 100

= 266% or 2.66

It means that a 10% increase in revenue should result in (10% X 2.66) 26% increase in operating profit (10% x 2.66).

Examples:

There are several examples of industries in which fixed cost is higher than the variable cost. The best example is the IT industry. This industry has a higher cost of salaries and lower variable costs related to software sales or service. In contrast, an e-commerce industry can have a higher variable cost and low fixed cost, and thus the degree of operating leverage will be lower compared to an IT industry.

Therefore an IT industry can improve its operating profits by generating higher sales volume. Whereas, the E-commerce industry can improve its operating profit by controlling or reducing its variable cost.

During a recessionary scenario, a lack of high sales volume can hamper companies (with high fixed cost) to cover their fixed costs, and impact their profitability. In a highly inflationary scenario or an expansion phase of the economy, the variable cost can rise drastically and impact companies’ profitability, if not controlled or reduced.

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