You will learn what the concept of “operating leverage” means in this lesson, including several different methods to calculate it and interpret it for real companies. You’ll also learn why it sometimes doesn’t tell you as much as you think it does.
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Table of Contents:
0:57 What Does Operating Leverage Mean?
5:16 Formulas to Calculate Operating Leverage
15:25 How to Interpret Operating Leverage in Real Life
20:21 Recap and Summary
What Does Operating Leverage Mean?
Operating leverage relates to a company’s fixed vs. variable costs – a company with a higher percentage of fixed costs is said to have “high operating leverage,” because as its sales grow, more of those sales trickle down into operating income.
For example, software companies tend to have high operating leverage because most of their spending happens upfront in the product development process.
Selling each additional copy of a software product costs very little since the distribution is almost free and there are no “raw materials.”
On the other hand, consulting or services companies have low operating leverage because most of their spending is variable: as sales increase, their spending increases in lockstep, and as sales decrease, their spending also decreases.
So the end result is that operating leverage introduces higher potential rewards, but also greater risk.
If a company’s sales increase, it helps to have higher operating leverage. But if they decrease, higher operating leverage hurts them because they won’t be able to reduce spending as quickly.
Formulas to Calculate Operating Leverage
There are several different formulas for calculating operating leverage:
Formula 1: Fixed Costs / (Fixed Costs + Variable Costs)
The problem with this one is that most companies don’t spell out what is a fixed vs. variable cost in their filings.
Formula 2: % Change in Operating Income / % Change in Sales
Formula 3: Net Income / Fixed Costs
Formula 4: Contribution Margin / Operating Margin
In practice, we tend to use the second formula: the % change in operating income divided by the % change in sales, because it’s the easiest one to apply when you have limited information.
However, the other formulas can be useful if you have additional insight into the company’s fixed vs. variable costs.
How to Interpret Operating Leverage in Real Life
This metric is MOST meaningful when you calculate it for companies in the same industry with roughly the same operating margins.
So it doesn’t make sense to use it to compare a software company to a manufacturing company, or to compare a biotech startup to a mature media company.
As a company’s operating leverage increases, each *percentage* of sales growth will translate into a higher *percentage* of operating income growth.
Consider Company A, with revenue of $1 billion, operating income of $200 million, and operating leverage of 2.0x, and Company B, with revenue of $1 billion, operating income of $200 million, and operating leverage of 1.0x.
"Operating leverage" means that when Company A’s revenue increases by 10%, its operating income will increase by 20%, so it will have operating income of $240 million on revenue of $1.1 billion.
On the other hand, Company B’s operating income will increase by only 10%, so it will rise to $220 million on revenue of $1.1 billion.
In the “Upside” case when sales increase, this is positive because Company A will earn more operating income from those additional sales.
But if sales decrease, Company A is worse off because it can’t cut its expenses to match its falling sales to the same degree that Company B can.
So it’s similar to debt in leveraged buyouts: more debt increases the potential rewards, but also the risk.
On balance, most investors prefer companies with high operating leverage simply because it makes it easier to earn out-sized returns – but it also depends on the investment firm’s strategy, the industry, and the companies involved.