101: Operating Leverage

By Gregg Schoenberg Monday, March 18, 2013

In our recent posts on breakeven analysis and capital structure we touched upon a very important concept that all business owners should understand: leverage. Employing fixed costs rather than variable costs increases a firm’s operating leverage, while issuing debt rather than equity increases financial leverage.

 

Both types of leverage can lead to greater profits, but both also increase risk. This week we’ll explore the effects of operating leverage, and next week we’ll take a look at financial leverage.

 

Business owners often have to choose between investing in fixed costs or variable costs. For example, a purchasing manager may need to determine whether it makes sense to invest a substantial amount of money in a new computer system (a fixed cost) that can reduce the amount of time its hourly employees spend producing a certain product (a variable cost).

 

If the purchasing manager chooses to replace variable costs with fixed costs by buying the new system then he is increasing the firm’s operating leverage.

 

We know that increasing operating leverage brings the potential for greater profits, but it also entails taking on more risk. So how does the purchasing manager make his decision? We can start to answer this question by looking at a simple table that examines the relationship between fixed costs, variable costs, and profits.

 

Scenario 1: Fixed Costs = $10,000, Variable Costs = $10.00

Price Quantity Total Fixed Variable Total Total Profit/
Per Unit Sold Revenue Costs Costs Per Unit Variable Cost Costs Loss

 $20.00

0

 $-

 $10,000.00

 $10.00

 $-

 $10,000.00

 $(10,000.00)

 $20.00

250

 $5,000.00

 $10,000.00

 $10.00

 $2,500.00

 $12,500.00

 $(7,500.00)

 $20.00

500

 $10,000.00

 $10,000.00

 $10.00

 $5,000.00

 $15,000.00

 $(5,000.00)

 $20.00

750

 $15,000.00

 $10,000.00

 $10.00

 $7,500.00

 $17,500.00

 $(2,500.00)

 $20.00

1000

 $20,000.00

 $10,000.00

 $10.00

 $10,000.00

 $20,000.00

 $-

 $20.00

1250

 $25,000.00

 $10,000.00

 $10.00

 $12,500.00

 $22,500.00

 $2,500.00

 $20.00

1500

 $30,000.00

 $10,000.00

 $10.00

 $15,000.00

 $25,000.00

 $5,000.00

 $20.00

1750

 $35,000.00

 $10,000.00

 $10.00

 $17,500.00

 $27,500.00

 $7,500.00

 $20.00

2000

 $40,000.00

 $10,000.00

 $10.00

 $20,000.00

 $30,000.00

 $10,000.00

 $20.00

2250

 $45,000.00

 $10,000.00

 $10.00

 $22,500.00

 $32,500.00

 $12,500.00

 $20.00

2500

 $50,000.00

 $10,000.00

 $10.00

 $25,000.00

 $35,000.00

 $15,000.00

               

Scenario 2: Fixed Costs = $15,000, Variable Costs = $7.00

  Quantity Total Fixed Variable Total Total Profit/
  Sold Revenue Costs Costs Per Unit Variable Cost Costs Loss

 $20.00

0

 $-

 $15,000.00

 $7.00

 $-

 $15,000.00

 $(15,000.00)

 $20.00

250

 $5,000.00

 $15,000.00

 $7.00

 $1,750.00

 $16,750.00

 $(11,750.00)

 $20.00

500

 $10,000.00

 $15,000.00

 $7.00

 $3,500.00

 $18,500.00

 $(8,500.00)

 $20.00

750

 $15,000.00

 $15,000.00

 $7.00

 $5,250.00

 $20,250.00

 $(5,250.00)

 $20.00

1000

 $20,000.00

 $15,000.00

 $7.00

 $7,000.00

 $22,000.00

 $(2,000.00)

 $20.00

1154

 $23,080.00

 $15,000.00

 $7.00

 $8,078.00

 $23,078.00

 $2.00

 $20.00

1250

 $25,000.00

 $15,000.00

 $7.00

 $8,750.00

 $23,750.00

 $1,250.00

 $20.00

1500

 $30,000.00

 $15,000.00

 $7.00

 $10,500.00

 $25,500.00

 $4,500.00

 $20.00

1750

 $35,000.00

 $15,000.00

 $7.00

 $12,250.00

 $27,250.00

 $7,750.00

 $20.00

2000

 $40,000.00

 $15,000.00

 $7.00

 $14,000.00

 $29,000.00

 $11,000.00

 $20.00

2250

 $45,000.00

 $15,000.00

 $7.00

 $15,750.00

 $30,750.00

 $14,250.00

 $20.00

2500

 $50,000.00

 $15,000.00

 $7.00

 $17,500.00

 $32,500.00

 $17,500.00

 

Let’s assume that the new software carries a license fee of $5,000 a month and reduces variable costs per unit from $10.00 to $7.00 Scenario 1 represents the purchasing manager’s current situation without purchasing the computer system and Scenario 2 shows what his firm’s cost structure will look like if he goes ahead and buys the system. There are two important takeaways that we can draw from this example that hold true any time you replace variable costs with fixed costs.

 

First is that the break-even level of sales rises, in this case from 1,000 units to 1,154. Second is that losses are magnified below the break-even point, while profits increase more rapidly once breakeven has been surpassed; in our example each additional 250 units sold increased profits by $2,500 in Scenario 1 and $3,250 in Scenario 2.

 

So if our purchasing manager is confident that his company can surpass its breakeven point on a consistent basis, then it probably makes sense to go ahead with the purchase. But if the company’s sales have a history of being choppy and it often operates in the red for months at a time, then buying the new software may be an unwise use of operating leverage.

 

An easy way to measure your company’s operating leverage is to get out your income statement and balance sheet and calculate your fixed asset turnover ratio by dividing your total sales by your fixed assets. The lower this number is, the more operating leverage you are using.

 

Of course, using a substantial amount of operating leverage is in itself not necessarily a cause for concern. If you are running an airline or operating a construction-rental equipment business you’re going to need a substantial investment in fixed assets and will thus be utilizing a high degree of operating leverage. That’s just the nature of those businesses.

 

If, on the other hand, you’re in the clothing retail or software business then you should be employing significantly less operating leverage than those in the aforementioned industries that are more reliant on fixed assets.

 

So when assessing the appropriate level of operating leverage for your firm it can be very helpful to compare it to publicly traded companies in your industry, most of whom have their financial statements available for free online. And if you’ve got questions about how much leverage you should be using, you’ll definitely want to consult with your accountant or a trusted investment professional.

More By Gregg Schoenberg
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