# Operating Leverage

Guide to Understanding the Operating Leverage Concept

• Conceptually, what is the meaning of operating leverage?
• Which formula is used to calculate the operating leverage of a company?
• If a company has high operating leverage, how are its margins and scalability impacted?
• When might high operating leverage result in adverse effects to a company?

## How to Calculate Operating Leverage

Companies with a high degree of operating leverage (DOL) have a greater proportion of fixed costs that remain relatively unchanged under different production volumes, whereas those with low operating leverage have cost structures comprised of comparatively more variable costs that are directly tied to production volume.

• Fixed Costs: Fixed costs can be thought of as costs that are incurred and need to be paid out irrespective of the sales performance and production volume of a company. As a result, fixed costs tend to remain relatively constant. For example, rent for office space would be considered a fixed cost because the amount due each month is based on a contractual agreement – and thus, the rental cost is constant and independent of sales volume.
• Variable Costs: Conversely, variable costs are directly tied to a company’s sales, meaning that such costs fluctuate based on sales performance in the given period. An example of variable costs is the delivery/shipping fee associated with the sale of products. The higher the volume of products produced and purchased by customers, the more delivery/shipping fees incurred by the company (and vice versa).

The reason operating leverage is an essential metric to track is because the relationship between the fixed and variable costs can significantly influence a company’s scalability and profitability.

As a company generates revenue, operating leverage is among the most influential factors that determine how much of that incremental revenue actually trickles down to operating income (i.e. profit).

The more fixed costs there are, the more sales a company must generate in order to reach its break-even point, which is when a company’s revenue is equivalent to the sum of its total costs.

## Degree of Operating Leverage (DOL) and Break-Even Analysis

Companies with higher leverage possess a greater risk of producing insufficient profits since the break-even point is positioned higher.

• If a company has high operating leverage, each additional dollar of revenue can potentially be brought in at higher profits after the break-even point has been exceeded. Thus, each marginal unit is sold at a lesser cost, creating the potential for greater profitability since fixed costs such as rent and utilities remain the same regardless of output.
• 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. Here, as more revenue is produced, the growth in the variable costs offsets the additional revenue and limits the company’s capacity to endure periods of lackluster sales performance (i.e., sustain its profit margins to stay in line with historical levels).

When a company’s revenue increases, having a high degree of leverage tends to be beneficial to its profit margins and FCFs.

However, if revenue declines, the leverage can end up being detrimental to the margins of the company because the company is restricted in its ability to implement potential cost-cutting measures.

## Industries with High vs. Low Operating Leverage

Listed below in the table are some examples of industries with high and low DOL.

 High DOL Low DOL Telecommunications (Hardware) Airlines & Leisure Energy / Oil & Gas Pharmaceuticals Professional Services (Consulting, Legal, etc.) Retailers E-Commerce Restaurants and Food Services

A shared trait for high DOL industries is that to get the business started, a large upfront payment/investment is required.

For instance, a pharmaceutical drug manufacturer must spend significant amounts of capital to even get a drug designed and have a chance of receiving approval from the FDA, which is a very costly and time-consuming process.

Hence, less established pharmaceutical companies are often forced to increase the pricing of their drugs to just break even and cover these costs, which is typically met with much criticism from the general public (i.e., accusations of “price gouging” in pharma).

The shared characteristic of low DOL industries is that spending is tied to demand, and there are more potential cost-cutting opportunities.

For example, a clothing retailer must spend a decent amount of capital to get started and begin operating in terms of finding a physical location and purchasing the initial inventory to sell to customers at its store, but the required investment is marginal relative to an airline’s spending needs (e.g., purchasing aircraft, fuel, continuous maintenance).

Furthermore, another important distinction lies in how the vast majority of a clothing retailer’s future costs are unrelated to the foundational expenditures the business was founded upon (i.e., telecom ➝ network infrastructure, airlines ➝ aircraft fleet, pharmaceutical ➝ approved drugs available in the market).

But rather, the clothing retailer’s expenses going forward will mostly be related to:

1. Inventory Orders (Continually Replenished)
2. Employee Compensation/Payroll (Constant Hiring, Schedules on “As-Needed” Basis)

These two costs are conditional on past demand volume patterns (and future expectations). Since both the number of employees hired (and the number of hours worked), as well as the volume of inventory purchased, are “adjustable” factors, this provides the retailer a significant “cushion” in being able to reduce costs if deemed necessary.

###### Liquidity Implications

The catch behind having higher DOL is that for the company to receive the positive benefits, its revenue must be recurring and non-cyclical.

• Non-Cyclical: If the performance of a company is non-cyclical, its sales are stable throughout different economic cycles (and are typically not as impacted by other external factors – e.g., commodity prices)
• Cyclical: For a cyclical company, its sales tend to deviate to a much larger degree based on current economic conditions and are influenced by external, often unpredictable factors

If sales and customer demand turned out lower than anticipated, a high DOL company could end up in financial ruin over the long run. As a result, companies with high DOL and in a cyclical industry are required to hold more cash on hand in anticipation of a potential shortfall in liquidity.

For this reason, many private equity firms attempt to acquire companies with high DOL for the scalability benefits, but due to the use of significant leverage (i.e., debt financing) to fund the purchase, private equity firms will usually avoid cyclical companies.

A company with high DOL coupled with a large amount of debt in its capital structure and cyclical sales could result in a disastrous outcome if the economy were to enter a recessionary environment.

## Telecom Company vs. Consulting Firm Operating Leverage

An example of a company with high operating DOL would be a telecom company that has completed a build-out of its network infrastructure.

• Starting out, the telecom company must incur substantial upfront capital expenditures (CapEx) to enable connectivity capabilities and set up its network (e.g., equipment purchases, construction, security implementations).
• However, following this initial period of high cash outflows as the network is built out, each new customer acquisition comes at a low incremental cost – the cost of adding one customer to the existing network is inexpensive relative to the initial expenses. Later on, the vast majority of expenses are going to be maintenance-related (i.e., replacements, minor updates) because the core infrastructure has already been set up.
• If all goes as planned, the initial investment will be earned back eventually and what remains is a high-margin company with recurring revenue. In this best-case scenario of a company with high DOL, earning outsized profits on each incremental sale becomes plausible, but this type of outcome is never guaranteed.
• In a contrasting scenario, if sales were underwhelming for this telecom company, its cost structure being comprised primarily of fixed costs could be damaging since the company is restricted in terms of its flexibility to cut costs in order to uphold margins.
• Of course, the company can still identify areas where minor cost-cutting could be done, but the concentrated sources of spending cannot be reduced (i.e., the capabilities and network system must remain operating as usual – otherwise there would be lower product/service quality for existing customers and an increased risk of losing those customers, or even a potential breach of the contract if the changes were material and violated a customer agreement).
• If revenue increases, the benefit to operating margin would be greater, but if it were to decrease, the margins of the company could potentially face significant downward pressure.

For comparability, we can take a look at a consulting firm with a low DOL.

• If sales were to outperform expectations, the margin expansion (i.e., the increase in margins) would be minimal because the variable costs also would have increased (i.e. the consulting firm may have needed to hire more consultants).
• But if the consulting firm were to underperform and see low demand due to its low DOL (i.e., having a high portion of variable costs), management could easily reduce costs because the compensation of employees at a consulting firm is tied to the number of client engagements.
• If the volume of consulting projects is substantially down, that means fewer hours are billed to clients (less revenue), and the pay of consultants is reduced since a sizeable percentage of their total compensation – excluding the base salaries – is dependent on the number of hours worked (fewer expenses).
• Regardless of whether revenue increases or decreases, the margins of the company tend to stay within the same range.

## Operating Leverage Formula

In practice, the formula most often used to calculate operating leverage tends to be dividing the change in operating income by the change in revenue.

Intuitively, DOL represents the risk faced by a company as a result of its percentage split between fixed and variable costs – so, the formula is measuring the sensitivity of a company’s operating income based on the change in “top-line” revenue.

For both the numerator and denominator, the “change” (i.e., the delta symbol) refers to the year-over-year change (YoY) and can be calculated by dividing the current year balance by the prior year balance and then subtracting by 1.

As an example, if operating income grew from 10k to 15k (50% increase) and revenue grew from 20k to 25k (25% increase), the DOL would be 2.0x.

The 2.0x DOL implies that if revenue were to increase by 5.0%, operating income is anticipated to increase by 10.0%.

Or, if revenue fell by 10%, then that would result in a 20.0% decrease in operating income.

###### DOL Formula
• Operating Leverage = % Δ in Operating Income / % Δ in Revenue

A second approach to calculating DOL involves dividing the % contribution margin by the % operating margin. The formulas for the two necessary inputs are listed below:

1. Contribution Margin (%) = (Revenue – Variable Costs) ÷ Revenue
2. Operating Margin (%) = (Revenue – Variable Costs – Fixed Costs) ÷ Revenue

The contribution margin represents the percentage of revenue remaining after deducting just the variable costs, while the operating margin is the percentage of revenue left after subtracting out both variable and fixed costs.

However, companies rarely disclose an in-depth breakdown of their variable and fixed costs, which makes usage of this formula less feasible unless confidential internal company data is accessible.

###### DOL Formula
• Operating Leverage = % Contribution Margin / % Operating Margin

We’ll now move to a modeling exercise, which you can access by filling out the form below.

Submitting ...

## High Operating Leverage Calculation Example

To reiterate, companies with high DOL have the potential to earn more profits on each incremental sale as the business scales.

In our example, we are going to assess a company with high DOL under three different scenarios of units sold (the sales volume metric).

The revenue of the company in the base case (i.e., our baseline scenario against which all other cases will be compared) is calculated by multiplying the number of units sold by the selling price per unit (or the average selling price, ASP).

Since 10mm units of the product were sold at a \$25.00 per unit price, revenue comes out to \$250mm.

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. Upon multiplying the \$2.50 cost per unit by the 10mm units sold, we get \$25mm as the variable costs.

Now, we are ready to calculate the contribution margin, which is the \$250mm in total revenue minus the \$25mm in variable costs. This comes out to \$225mm as the contribution margin (which equals a margin of 90%).

In the next step, we deduct the \$100mm in fixed costs from the \$225 contribution margin to get \$125mm as the operating income (or EBIT), which comes out to be a 50% operating margin.

In the base case, the ratio between the fixed costs and variable costs is 4.0x (\$100mm ÷ \$25mm), while the DOL is 1.8x – which we calculated by dividing the contribution margin by the operating margin.

We can then extend this process for the “Upside” and “Downside” cases. The only difference now is that the number of units sold is 5mm higher in the upside case and 5mm lower in the downside case.

Revenue and variable costs are both impacted by the change in the units sold since all three metrics are correlated.

Under all three cases, the contribution margin remains constant at 90% because the variable costs increase (and decrease) based on the change in the units sold.

But since the fixed costs are \$100mm regardless of the number of units sold, the difference in operating margin amongst the cases is substantial, as highlighted below.

The operating margin in the base case is 50% as calculated earlier and the benefits of high DOL can be seen in the upside case.

However, the downside case is where we can see the negative side of high DOL, as the operating margin fell from 50% to 10% due to the decrease in units sold.

Despite the significant drop-off in the number of units sold (10mm to 5mm) and the coinciding decrease in revenue, the company likely had few levers to pull to limit the damage to its margins.

## Low Operating Leverage Calculation Example

Recall companies with a low DOL have a higher proportion of variable costs that depend on the number of unit sales for the specific period while having fewer fixed costs each month.

This company would fit into that categorization since variable costs in the “Base” case are \$200mm and fixed costs are only \$50mm. In addition, in this scenario, the selling price per unit is set to \$50.00 and the cost per unit is \$20.00, which comes out to a contribution margin of \$300mm in the base case (and 60% margin).

In the “Upside Case” we can see that despite a 5mm increase in units sold, the margin expansion was roughly only 3.3% (50.0% to 53.3%).

This shows how with increased scale, for companies with relatively low DOL, the benefits to margins are lessened.

However, in the downside case, although the number of units sold was cut in half (10mm to 5mm), the operating margin only suffered a 10.0% decrease from 50.0% to 40.0% – reflecting the downside protection afforded to companies with low DOL.

## Operating Leverage and Scalability

In the final section, we’ll go through an example projection of a company with a high fixed cost structure and calculate the DOL using the 1st formula from earlier.

Based on our hardcoded assumptions in Year 1, the ratio between fixed costs and variable costs is 5.0x (\$100mm: \$20mm). Here in our model, we have included two different scenarios to assess the impact the high fixed cost structure has on the company’s margins:

• Upside Case: Constant Revenue Growth Increase of 10% YoY
• Downside Case: Constant Revenue Growth Decrease of 10% YoY

From the screenshot below, we can see 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).

Next, if the case toggle is set to “Upside”, we can see that revenue is growing 10% each year and from Year 1 to Year 5, and the company’s operating margin expands from 40.0% to 55.8%. Just like the 1st example we had for a company with high DOL, we can see the benefits of DOL from the margin expansion of 15.8% throughout the forecast period.

Variable costs were 1: 5 of the fixed costs (\$20mm to \$100mm) in this cost structure for the 1st period, and this grows to roughly a ~1.5: 5 ratio by Year 5 (\$29mm to \$100mm).

But this comes out to only a \$9mm increase in variable costs whereas revenue grew by \$93mm (\$200mm to \$293mm) in the same time frame.

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.

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 the fixed costs of \$100mm each year.

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).

In closing, high operating leverage is not inherently good or bad for companies.

The decisive factor of whether a company should pursue a high or low DOL structure comes down to the risk tolerance of the investor/operator.

Like the risk stemming from the use of financial leverage (i.e., debt financing), DOL can result in higher profits in good times but simultaneously carries a higher risk of potential losses if the company’s operating performance underwhelms.

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