WallStreetMojo

WallStreetMojo

WallStreetMojo

MENUMENU
  • Free Tutorials
  • Certification Courses
  • 250+ Courses All In One Bundle
  • Login
Home » Investment Banking Tutorials » Financial Statement Analysis » Operating Leverage

Operating Leverage

What is Operating Leverage?

Operating Leverage is an accounting metric that helps the analyst in analyzing how a company’s operations are related to the company’s revenues; the ratio gives details about how much of a revenue increase will the company have with a specific percentage of sales increase – which puts the predictability of sales into the forefront.

Alternatively, Operating leverage can be defined as the capability of the firm to use its fixed expenses to generate better returns. We note from the above graph that companies like Accenture, Cognizant, Automatic Data Processing, and Paychex have lower Leverage (~1.0x), whereas companies like Delta Airlines, China Eastern Airlines, and National Grid have a higher Leverage.

Operating Leverage

Why some companies have higher operating leverage while others have lower leverage? What are the things we should be mindful of as financial analysts+?

Understanding the Company’s Costs

As we all know, no product is manufactured free of cost by any organization. Various costs are incurred to finally bring the product on the shelf, ready for the consumers to buy and consume. All these costs incurred can be bifurcated into two main categories – fixed costs and variable costs.

What are the fixed costs?

  • Well, as the name itself suggests, these costs are fixed, which will not change irrespective of the number of units produced.
  • E.g., Rent of the factory, which an organization pays on a monthly basis, will remain fixed irrespective of the fact that they produce 500 or 5,000 units of 5,00,000 units of the product.

What are the variable costs?

  • As opposed to fixed costs, variable costs vary with the number of units produced. In other words, there are directly proportionally with units produced.
  • E.g., Raw materials consumed in order to produce the finished product. Say the company is in the business of assembling a mobile phone, and the battery is a raw material for the company. In this case, the cost of batteries consumed will be a variable cost for the company as the volume is dependent directly on the volume of the total production of mobile phones in a given period of time.

What are semi-variable / semi-fixed costs?

  • Apart from the fixed and variable costs, there are costs that are neither completely fixed nor completely variable.
  • E.g., A Company promises its floor manager a salary of $ 1,000 + 2% of the cost price for every unit produced in a given month. In this case, $ 1,000 is a fixed cost which the company will have to pay even if there is no production at all. At the same time, 2% of the cost price paid is a variable cost, which will be in the case of no production.

Note: There is a thin line between the differentiation of fixed costs and variable costs. What is fixed for a given company, and a given situation may be variable for the same company for a different situation?

The best example is the manpower costs. The salary paid to an accountant is a fixed cost for whereas wages paid to the workers on per product is a variable cost. So even though both are included as manpower costs in a company, they can still be bifurcated into fixed and variable.

How to Interpret Operating Leverage?

Operating leverage measures the company’s fixed costs as a percentage of its total costs. A company with a higher fixed cost will have higher Leverage as compared to a company having a higher variable cost.

Popular Course in this category
Sale
All in One Financial Analyst Bundle (250+ Courses, 40+ Projects)
4.9 (1,067 ratings)
250+ Courses | 40+ Projects | 1000+ Hours | Full Lifetime Access | Certificate of Completion
View Course

Lower operating leverage –

  • This implies lower fixed costs and higher variable costs. In this case, a company has to achieve minimum sales, which will cover its fixed costs. Once it crosses the break-even point where all its fixed costs are covered, it can earn
  • Once it crosses the break-even point where all its fixed costs are covered, it can earn incremental profit in terms of Selling Price minus the Variable Cost, which will not be very substantial as the variable cost itself are high.
  • When the operating leverage is low and fixed costs are lower, we can also safely conclude that the break-even units which a company needs to sell in order to suffer a no loss & no profit equation will be comparatively lower.

Higher operating leverage –

  • This implies lower variable costs and higher fixed costs. Here, as the fixed costs are higher, the break-even point will be higher.
  • The company will have to sell the number of units to ensure no loss & no profit situation. On the other hand, the advantage here is that after the break-even is achieved, the company will earn a higher profit on every product as the variable cost is very low.
  • The company will have to sell a number of units to ensure no loss & no profit situation. On the other hand, the advantage here is that after the break-even is achieved, the company will earn a higher profit on every product as the variable cost is very low.

Companies generally prefer lower operating leverage so that even in cases where the market is slow, it would not be difficult for them to cover the fixed costs.

Related Topics – Income Statement Interpretation, Profit Margins

Operating Leverage Formula

It is the percentage change in operating profit relative to sales. It is also known as the “Degree of Operating Leverage or DOL.” Please note that the greater use of fixed costs, the greater the impact of a change in sales on the operating income of a company.

Degree of Operating Leverage Formula = % change in EBIT / % change in Sales.

Let us take a simple example.

  • Sales 2015 = $500, EBIT 2015 = $200
  • Sales 2014 = $400, EBIT 2014 = $150
  • % change in EBIT = ($200-$150)/$150 = 33%
  • % change in Sales = ($500-$400)/$400 = 25%
  • Degree of Operating Leverage = 33/25 = 1.32x

This means that for Operating profit changes by 2% for every 1% change in Sales.

Also, have a look at EBIT vs. EBITDA – Top differences.

Calculate Operating Leverage of Colgate

  • Colgate’s DOL = % change in EBIT / % change in Sales.
  • I have calculated the DOL for each year from 2008 – 2015.
  • Colgate’s DOL is very volatile as it ranges from 1x to 5x (excluding the year 2009 where sales growth was almost 0%).
  • It is expected that Colgate’s DOL to be higher as we note that Colgate has made significant investments in Property, plant, and equipment as well as intangible assets. Both these long term assets account for more than 40% of the total assets.

Colgate

Calculate Operating Leverage of Amazon

Let us now calculate Amazon’s DOL. Below is the snapshot of Amazon’s Income Statement for 2014, 2015 and 2016.Amazon - Operating Leverage

source: Amazon SEC Filings

DOL formula = % change in EBIT / % change in Sales

DOL of Amazon – 2016

  • % change in EBIT (2016) = (4,186-2,233)/2,233 =  87%
  • % change in Sales (2016) = (135,987 – 107,006)/107,006 =  27%
  • Amazon’s DOL (2016) = 87% / 27% = 3.27x

DOL  of Amazon – 2015

  • % change in EBIT (2015) = (2,233- 178)/174 =  1154%
  • % change in Sales (2015) = (107,006 – 88,988)/88,988 =  20%
  • Amazon’s DOL (2015) = 1154% / 20% = 57.02x

Reasons for Higher Leverage for Amazon

  • Higher Fixed Costs
  • Lower Variable Costs

Accenture Example

Accenture - Operating Leverage

source: Accenture SEC Filings

DOL  Formula = % change in EBIT / % change in Sales

DOL of Accenture – 2016

  • % change in EBIT (2016) = (4810,445 – 4,435,869)/4,435,869 =  8.4%
  • % change in Sales (2016) = (34,797,661 – 32,914,424)/32,914,424 =  5.7%
  • Accenture’s DOL (2016) = 8.4% / 5.7% = 1.5x

DOL of Accenture – 2015

  • % change in EBIT (2015) = (4,435,869 – 4,300,512 )/4,300,512 =  3.1%
  • % change in Sales (2015) = (32,914,424 – 31,874,678)/31,874,678 =  3.3%
  • Accenture’s DOL (2015) = 3.1% / 3.3% = 0.96x

Reasons for low DOL of Accenture

  • Lower Fixed Costs
  • Higher Variable Costs. Such companies bill clients on a per hour basis, and variable costs are in the form of developers/consultant’s salaries.

IT Services Firm Example

Salient Features of IT Services Firm –

  • Lower Fixed Costs
  • Variable Costs depend on the project and developer salaries.
  • Operating Leverage should be relatively lower

Below is the list of the Top IT Services firm and their DOL for the year of 2016-2017

S. No Name Market Cap ($ ‘000) Sales (2017 YoY Growth) EBIT (2017 YoY Growth) Operating Leverage
1 Accenture  82,307 5.7% 8.4% 1.48x
2 Cognizant Tech Solns  41,218 8.6% 6.9% 0.80x
3 Infosys 35,839 2.4% 1.1% 0.46x
4 Gartner 11,599 13.0% 6.0% 0.46x
5 CDW  9,978 7.6% 10.4% 1.36x
6 Leidos Holdings 8,071 49.5% 30.3% 0.61x
7 Xerox  7,485 -6.1% -9.9% 1.64x
8 EPAM Systems  4,524 26.9% 26.2% 0.97x
9 CACI International    3,113 13.0% 12.0% 0.92x

source: ycharts

  • We did the example of Accenture earlier and found that its DOLs are 1.48x.
  • Similarly, other IT Services Firm like Cognizant, Infosys, Gartner have DOLs closer to or less than 1.0x

Airline Sector Example

Salient features of the Airline Sector

  • Higher Fixed Costs
  • Lower Variable Costs (as compared to fixed costs)
  • Due to the above, this sector should have high Leverages.

Below is the list of some of the Top Airline companies along with their DOLs for 2016-2017

S. No Name Market Cap ($ ‘000) Sales (2017 YoY Growth) EBIT (2017 YoY Growth) Leverage
1 Delta Air Lines 37,838 -2.6% -10.9% 4.16x
2 Ryanair Holdings 27,395 1.1% 4.5% 3.92x
3 American Airlines Group  25,570 -2.0% -14.8% 7.50x
4 United Continental Holdings 21,773 -3.5% -16.0% 4.64x
5 China Eastern Airlines  11,174 -0.7% -6.7% 10.04x
6 China Southern Airlines  7,948 -2.8% -11.4% 4.07x
7 JetBlue Airways    7,825 3.4% 7.9% 2.35x

source: ycharts

  • Overall, the sector has a higher Operating Leverage (~4.0x)
  • China Eastern Airlines have a Leverage of 10.04x, whereas, American Airlines Group has a Leverage of 7.50x
  • Delta Airlines and Ryanair Holdings have DOL closer to 4.0x

Business Services Companies Example

Salient features of Business Services

  • Lower Fixed Costs
  • Higher Variable Costs
  • Should have lower DOL

Below is the list of Top Business Services Companies along with their 2016-17 Leverages

S. No Name Market Cap ($ ‘000) Sales (2017 YoY Growth) EBIT (2017 YoY Growth) DOL
1 Automatic Data Processing   46,790 6.7% 8.8% 1.31x
2 Fidelity National Info  29,752 40.1% 18.1% 0.45x
3 Paychex  20,558 6.8% 8.1% 1.20x
4 Equifax  17,297 18.1% 17.9% 0.99x
5 Verisk Analytics  14,304 13.3% 9.1% 0.69x
6 Global Payments 14,300 -24.0% -44.0% 1.83x
7 Fleetcor Technologies  13,677 7.6% 13.0% 1.72x
8 Rollins  9,019 5.9% 7.7% 1.30x
9 Broadridge Financial Soln  8,849 7.5% 7.2% 0.95x
10 Jack Henry & Associates  8,246 7.8% 13.8% 1.76x
11 Genpact 5,514 4.5% 2.0% 0.44x
12 ServiceMaster Global 5,293 5.9% 7.6% 1.29x
13 Booz Allen Hamilton Hldg  4,994 7.4% 8.9% 1.21x
14 Synnex  4,786 5.4% 7.1% 1.30x
15 Dun & Bradstreet   4,101 4.1% 6.6% 1.62x
16 Maximus   3,924 14.5% 10.3% 0.71x
17 CoreLogic  3,673 27.8% 35.3% 1.27x
18 Deluxe  3,410 4.3% 4.1% 0.94x

source: ycharts

  • We note that overall the sector has an Operating Leverage of closer to 1.0x
  • Automatic Data Processing has a leverage of 1.31x, whereas, Leverage of Booz Allen Hamilton is 1.21x

Utility Companies Example

Salient features of Utilities Sector

  • Higher Fixed Costs
  • Lower Variable Costs
  • The overall sector should have a higher Leverage as compared to business services or IT Services

Below is the list of Top utility companies with their Market Cap along with 2016-2017 DOLs

S. No Name Market Cap ($ ‘000) Sales (2017 YoY Growth) EBIT (2017 YoY Growth) Degree of Operating Leverage
1 National Grid 49,619 -1.3% -13.7% 10.37x
2 Dominion Energy  30,066 0.5% 2.6% 5.57x
3 Sempra Energy  28,828 -0.5% -15.5% 33.10x
4 Public Service Enterprise  22,623 -13.0% -46.8% 3.60x
5 Huaneng Power 10,902 -15.9% -54.2% 3.41x
6 AES  7,539 -4.0% -15.9% 3.95x
7 Black Hills 3,767 20.6% 647.1% 31.46x

source: ycharts

  • Overall the sector has a higher Leverage compared to other low capital intensive sectors. Most of the companies have operating leverage of more than 3.0x
  • National Grid has a DOL of 10.37x, whereas, Sempra Energy has a DOL of 33.10x

Conclusion

While we analyze a company, we must look at its Operating Leverage. DOL helps us evaluate how sensitive its operating income is with respect to changes in Sales. Higher DOL will result in a higher change in Operating income when sales increase. However, in the case of adverse situations of Sales decrease, such companies’ Operating Income will get hit the most. On the other hand, companies with Lower DOL will see only a proportional change in Operating Income.

As an analyst, you should fully understand a company’s cost structure, fixed costs, variable costs, and operating leverage. This information is very helpful when you forecast financials and prepare its financial model in excel.

Recommended Articles –

This article has been a guide to what is Operating Leverage, formula, and its calculation. Here we also take a degree of operating leverage examples of companies like Colgate, Amazon, Accenture, and also sectors including IT Services, Utilities, Business Services, and Airlines.

  • Leverage Ratios Formula
  • Degree of Operating Leverage Calculation
  • Operating Lease Examples
  • Leveraged Lease Definition
59 Shares
Share
Tweet
Share
Primary Sidebar
Footer
COMPANY
About
Reviews
Contact
Privacy
Terms of Service
RESOURCES
Blog
Free Courses
Free Tutorials
Investment Banking Tutorials
Financial Modeling Tutorials
Excel Tutorials
Accounting Tutorials
Financial Statement Analysis
COURSES
All Courses
Financial Analyst All in One Course
Investment Banking Course
Financial Modeling Course
Private Equity Course
Venture Capital Course
Excel All in One Course

Copyright © 2021. CFA Institute Does Not Endorse, Promote, Or Warrant The Accuracy Or Quality Of WallStreetMojo. CFA® And Chartered Financial Analyst® Are Registered Trademarks Owned By CFA Institute.
Return to top

WallStreetMojo

Free Investment Banking Course

IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials

* Please provide your correct email id. Login details for this Free course will be emailed to you

Book Your One Instructor : One Learner Free Class
WallStreetMojo

Free Investment Banking Course

IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials

* Please provide your correct email id. Login details for this Free course will be emailed to you

Let’s Get Started
Please select the batch
Saturday - Sunday 9 am IST to 5 pm IST
Saturday - Sunday 9 am IST to 5 pm IST

This website or its third-party tools use cookies, which are necessary to its functioning and required to achieve the purposes illustrated in the cookie policy. By closing this banner, scrolling this page, clicking a link or continuing to browse otherwise, you agree to our Privacy Policy

Login

Forgot Password?

WallStreetMojo

Free Ratio Analysis Course

Step by Step Guide to Calculating Financial Ratios in excel

New Year Offer - All in One Financial Analyst Bundle (250+ Courses, 40+ Projects) View More