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 operating profit 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

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Operating Leverage (wallstreetmojo.com)

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.

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.

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 MarginsProfit MarginsProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more

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 differencesEBIT Vs. EBITDA - Top DifferencesEBIT signifies the operating profit the company makes before the inclusion of interest and tax expenses. In comparison, EBITDA determines the company's overall operational profitability by summing the depreciation and amortization expenses to the operating profit.read more.

Calculate Operating Leverage of Colgate

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. NoNameMarket Cap ($ ‘000)Sales (2017 YoY Growth)EBIT (2017 YoY Growth)Operating Leverage
1Accenture 82,3075.7%8.4%1.48x
2Cognizant Tech Solns 41,2188.6%6.9%0.80x
3Infosys35,8392.4%1.1%0.46x
4Gartner11,59913.0%6.0%0.46x
5CDW 9,9787.6%10.4%1.36x
6Leidos Holdings8,07149.5%30.3%0.61x
7Xerox 7,485-6.1%-9.9%1.64x
8EPAM Systems 4,52426.9%26.2%0.97x
9CACI International   3,11313.0%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. NoNameMarket Cap ($ ‘000)Sales (2017 YoY Growth)EBIT (2017 YoY Growth)Leverage
1Delta Air Lines37,838-2.6%-10.9%4.16x
2Ryanair Holdings27,3951.1%4.5%3.92x
3American Airlines Group 25,570-2.0%-14.8%7.50x
4United Continental Holdings21,773-3.5%-16.0%4.64x
5China Eastern Airlines 11,174-0.7%-6.7%10.04x
6China Southern Airlines 7,948-2.8%-11.4%4.07x
7JetBlue Airways   7,8253.4%7.9%2.35x

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. NoNameMarket Cap ($ ‘000)Sales (2017 YoY Growth)EBIT (2017 YoY Growth)DOL
1Automatic Data Processing  46,7906.7%8.8%1.31x
2Fidelity National Info 29,75240.1%18.1%0.45x
3Paychex 20,5586.8%8.1%1.20x
4Equifax 17,29718.1%17.9%0.99x
5Verisk Analytics 14,30413.3%9.1%0.69x
6Global Payments14,300-24.0%-44.0%1.83x
7Fleetcor Technologies 13,6777.6%13.0%1.72x
8Rollins 9,0195.9%7.7%1.30x
9Broadridge Financial Soln 8,8497.5%7.2%0.95x
10Jack Henry & Associates 8,2467.8%13.8%1.76x
11Genpact5,5144.5%2.0%0.44x
12ServiceMaster Global5,2935.9%7.6%1.29x
13Booz Allen Hamilton Hldg 4,9947.4%8.9%1.21x
14Synnex 4,7865.4%7.1%1.30x
15Dun & Bradstreet  4,1014.1%6.6%1.62x
16Maximus  3,92414.5%10.3%0.71x
17CoreLogic 3,67327.8%35.3%1.27x
18Deluxe 3,4104.3%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. NoNameMarket Cap ($ ‘000)Sales (2017 YoY Growth)EBIT (2017 YoY Growth)Degree of Operating Leverage
1National Grid49,619-1.3%-13.7%10.37x
2Dominion Energy 30,0660.5%2.6%5.57x
3Sempra Energy 28,828-0.5%-15.5%33.10x
4Public Service Enterprise 22,623-13.0%-46.8%3.60x
5Huaneng Power10,902-15.9%-54.2%3.41x
6AES 7,539-4.0%-15.9%3.95x
7Black Hills3,76720.6%647.1%31.46x

source: ycharts

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 structureCost StructureCost Structure refers to those costs or expenses (fixed as well as variable costs) which businesses will incur or will have to incur to produce the desired objective of the business; such costs include the cost of purchasing the raw material to the cost of packaging the finished products.read more, fixed costs, variable costs, and operating leverage. This information is very helpful when you forecast financials and prepare its financial model in excelFinancial Model In ExcelFinancial modeling in Excel refers to a tool used for preparing the expected financial statements predicting the company's financial performance in a future period using the assumptions and historical performance information.read more.

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.

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *