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December 28 2006 | Filed Under Stocks
Return on equity, free cash flow (FCF) and price-to-earnings ratios are a few
of the common methods used for gauging a company's well-being and risk level.
One measure that doesn't get enough attention is operating leverage, which
captures the relationship between a company's fixed and variable costs. (To
read more on ratios, see Analyze Investments Quickly With Ratios and the Ratio
Analysis Tutorial.)
In good times, operating leverage can supercharge profit growth. In bad times,
it can crush profits. Even a rough idea of a firm's operating leverage can tell
you a lot about a company's prospects. In this article, we'll give you a
detailed guide to understanding operating leverage.
What Is Operating Leverage?
Essentially, operating leverage boils down to an analysis of fixed costs and
variable costs. Operating leverage is highest in companies that have a high
proportion of fixed operating costs in relation to variable operating costs.
This kind of company uses more fixed assets in the operation of the company.
Conversely, operating leverage is lowest in companies that have a low
proportion of fixed operating costs in relation to variable operating costs.
(To learn more about operating and financial leverage, read What are the risks
of having both high operating leverage and high financial leverage?)
The benefits of high operating leverage can be immense. Companies with high
operating leverage can make more money from each additional sale if they don't
have to increase costs to produce more sales. The minute business picks up,
fixed assets such as property, plant and equipment (PP&E), as well as existing
workers, can do a whole lot more without adding additional costs. Profit
margins expand and earnings soar faster than revenues. (Read more about margins
in The Bottom Line On Margins and Measuring Company Efficiency.)
The best way to explain operating leverage is by way of examples. Take, for
example, a software maker such as Microsoft. The bulk of this company's cost
structure is fixed and limited to upfront development and marketing costs.
Whether it sells one copy or 10 million copies of its latest Windows software,
Microsoft's costs remain basically unchanged. So, once the company has sold
enough copies to cover its fixed costs, every additional dollar of sales
revenue drops into the bottom line. In other words, Microsoft possesses
remarkably high operating leverage.
By contrast, a retailer, such as Wal-Mart demonstrates relatively low operating
leverage. The company has fairly low levels of fixed costs, while its variable
costs are large. Merchandise inventory represents Wal-Mart's biggest cost. For
each product sale that Wal-Mart rings in, the company has to pay for the supply
of that product. As a result, Wal-Mart's cost of goods sold (COGS) continues to
rise as sales revenues rise.
Risky Business
Operating leverage can tell investors a lot about a company's risk profile and
although high operating leverage can often benefit companies, companies with
high operating leverage are also vulnerable to sharp economic and business
cycle swings.
As stated above, in good times, high operating leverage can supercharge profit.
But companies with a lot of costs tied up in machinery, plants, real estate and
distribution networks can't easily cut expenses to adjust to a change in
demand. So, if there is a downturn in the economy, earnings don't just fall,
they can plummet.
Consider the software developer Inktomi. During the 1990s investors marveled at
the nature of its software business. The company spent tens of millions of
dollars to develop each of its digital delivery and storage software programs.
But thanks to the internet, Inktomi's software could be distributed to
customers at almost no cost. In other words, the company had close to zero cost
of goods sold. After its fixed development costs were recovered, each
additional sale was almost pure profit.
After the collapse of dotcom technology market demand in 2000, Inktomi suffered
the dark side of operating leverage. As sales took a nosedive, profits swung
dramatically to a staggering $58 million loss in Q1 of 2001 plunging down
from the $1 million profit the company had enjoyed in Q1 of 2000. The high
leverage involved in counting on sales to repay fixed costs can put companies
and their shareholders at risk. High operating leverage during a downturn can
be an Achilles heel, putting pressure on profit margins and making a
contraction in earnings unavoidable.
Indeed, companies such as Inktomi, with high operating leverage, typically have
larger volatility in their operating earnings and share prices. As a result,
investors need to treat these companies with caution. (To read more about the
dotcom bust, see The Greatest Market Crashes and When Fear And Greed Take
Over.)
Measuring Operating Leverage
Operating leverage occurs when a company has fixed costs that must be met
regardless of sales volume. When the firm has fixed costs, the percentage
change in profits due to changes in sales volume is greater than the percentage
change in sales. With positive (i.e. greater than zero) fixed operating costs,
a change of 1% in sales produces a change of greater than 1% in operating
profit.
A measure of this leverage effect is referred to as the degree of operating
leverage (DOL), which shows the extent to which operating profits change as
sales volume changes. This indicates the expected response in profits if sales
volumes change. Specifically, DOL is the percentage change in income (usually
taken as earnings before interest and tax, or EBIT) divided by the percentage
change in the level of sales output.
For illustration, let's say a software company has invested $10 million into
development and marketing for its latest application program, which sells for
$45 per copy. Each copy costs the company $5 to sell. Sales volume reaches one
million copies.
So, the software company enjoys a DOL of 1.33. In other words, a 25% change in
sales volume would produce a 1.33 x 25% = 33% change in operating profit.
Unfortunately, unless you are a company insider, it can be very difficult to
acquire all of the information necessary to measure a company's DOL. Consider,
for instance, fixed and variable costs, which are critical inputs for
understanding operating leverage. It would be surprising if companies didn't
have this kind of information on cost structure, but companies are not required
to disclose such information in published accounts.
Investors can come up with a rough estimate of DOL by dividing the change in a
company's operating profit by the change in its sales revenue.
Looking back at a company's income statements, investors can calculate changes
in operating profit and sales. Investors can use the change in EBIT divided by
the change in sales revenue to estimate what the value of DOL might be for
different levels of sales. This allows investors to estimate profitability
under a range of scenarios.
Conclusion
Be very careful using either of these approaches. They can be misleading if
applied indiscriminately. They do not consider a company's capacity for growing
sales. Few investors really know whether a company can expand sales volume past
a certain level without, say, sub-contracting to third-parties or further
capital investment, which would increase fixed costs and alter operational
leverage. At the same time, a company's prices, product mix and cost of
inventory and raw materials are all subject to change. Without a good
understanding of the company's inner workings, it is difficult to get a truly
accurate measure of the DOL.
Nevertheless, it worth getting even a rough idea of a company's operating
leverage. Even if it is not 100% accurate, knowledge of a company's DOL can
help us assess the level of risk it offers to investors.
Although you need to be careful when looking at operating leverage, it can tell
you a lot about a company and its future profitability. Investors can get a
rough sense of the company's outlook and risk in the face of changing market
conditions. While operating leverage doesn't tell the whole story, it certainly
can help.
by Ben McClure