Economic operating leverage

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• Cost of capital
• Return on equity
• Business cycle
• Fixed costs
• Variable costs
• Revenue
• Net income
• Earnings before interest and taxes
• Break-even point
• Profitability
• Capital structure
• Cash flow
• Financial distress
• Risk profile
• Contribution margin

What Is Economic Operating Leverage?

Economic operating leverage refers to the degree to which a firm's fixed costs are a part of its overall cost structure. It falls under the broader financial category of corporate finance, which analyzes how companies fund their operations and make investment decisions. A company with high economic operating leverage has a larger proportion of fixed costs relative to its variable costs. This means that once a certain sales volume is achieved, each additional sale contributes significantly to profitability because the incremental variable costs are relatively low. Conversely, a company with low economic operating leverage has a greater proportion of variable costs, making its overall cost structure more adaptable to changes in sales volume.

History and Origin

The concept of economic operating leverage, rooted in the distinction between fixed and variable costs, became more formalized with the rise of industrialization and mass production. As businesses invested heavily in machinery, plants, and extensive infrastructure, these large upfront expenditures became significant fixed costs. The early 20th century saw management accounting principles evolving to better understand how these fixed investments impacted profitability as production volumes changed. The recognition that a high proportion of fixed costs could amplify changes in sales into magnified changes in profits and losses became a crucial insight for business planning and risk profile assessment. Research into how leverage impacts business cycle fluctuations has been a continuous area of study, with academic papers exploring its effects on macroeconomic variables like investment and lending, particularly during economic downturns.¹¹, ¹²

Key Takeaways

• Economic operating leverage measures the proportion of fixed costs in a company's total cost structure.
• High operating leverage can lead to disproportionately large increases in profits when sales rise, but also to significant losses when sales decline.
• Businesses with high operating leverage require a higher sales volume to reach their break-even point.
• Understanding a company's economic operating leverage is crucial for assessing its business risk and forecasting earnings before interest and taxes.
• Companies in capital-intensive industries typically exhibit higher economic operating leverage.

Formula and Calculation

The Degree of Operating Leverage (DOL) is a common measure of economic operating leverage. It quantifies the sensitivity of a company's operating income to changes in sales revenue.

The formula for the Degree of Operating Leverage is:

Alternatively, DOL can be calculated using the following formula:

Where:

• Contribution Margin = Sales Revenue - Variable Costs
• Earnings Before Interest and Taxes (EBIT) = Sales Revenue - Variable Costs - Fixed Costs

A higher DOL indicates that a company has a greater proportion of fixed costs and, therefore, greater economic operating leverage.

Interpreting the Economic Operating Leverage

Interpreting economic operating leverage involves understanding its implications for a company's financial performance and stability. A high degree of operating leverage means that a small percentage change in sales can result in a much larger percentage change in operating income. This can be highly beneficial during periods of strong sales growth, as profits can soar quickly. However, it also means that during a sales downturn, operating income can plummet rapidly, potentially leading to significant losses or even financial distress.

Conversely, a company with low economic operating leverage, characterized by a higher proportion of variable costs, will experience less volatile changes in operating income in response to sales fluctuations. While it may not see the same dramatic profit increases during boom periods, it also faces less severe profit declines during economic contractions. This makes such companies generally less risky in terms of business operations. Assessing operating leverage helps analysts and investors evaluate a company's inherent business risk, independent of its financing decisions.

Hypothetical Example

Consider two hypothetical companies, Company A and Company B, both with sales of $1,000,000.

Company A (High Operating Leverage)

• Sales Revenue: $1,000,000
• Variable Costs: $200,000
• Fixed Costs: $600,000
• Earnings Before Interest and Taxes (EBIT): $1,000,000 - $200,000 - $600,000 = $200,000
• Contribution Margin: $1,000,000 - $200,000 = $800,000
• DOL for Company A: $\frac{\$800,000}{\$200,000} = 4.0$

Now, let's say sales increase by 10% for both companies.

Company A with 10% Sales Increase

• New Sales Revenue: $1,100,000
• New Variable Costs: $200,000 * 1.10 = $220,000
• Fixed Costs: $600,000 (remain constant)
• New EBIT: $1,100,000 - $220,000 - $600,000 = $280,000
• Percentage Change in EBIT: $\frac{\$280,000 - \$200,000}{\$200,000} = 40\%$
• Notice that a 10% increase in sales led to a 40% increase in EBIT for Company A, reflecting its high economic operating leverage.

Company B (Low Operating Leverage)

• Sales Revenue: $1,000,000
• Variable Costs: $700,000
• Fixed Costs: $100,000
• Earnings Before Interest and Taxes (EBIT): $1,000,000 - $700,000 - $100,000 = $200,000
• Contribution Margin: $1,000,000 - $700,000 = $300,000
• DOL for Company B: $\frac{\$300,000}{\$200,000} = 1.5$

Company B with 10% Sales Increase

• New Sales Revenue: $1,100,000
• New Variable Costs: $700,000 * 1.10 = $770,000
• Fixed Costs: $100,000 (remain constant)
• New EBIT: $1,100,000 - $770,000 - $100,000 = $230,000
• Percentage Change in EBIT: $\frac{\$230,000 - \$200,000}{\$200,000} = 15\%$
• For Company B, a 10% increase in sales resulted in only a 15% increase in EBIT, demonstrating lower economic operating leverage.

This example clearly illustrates how economic operating leverage amplifies the impact of sales changes on a company's operating profits.

Practical Applications

Economic operating leverage is a critical concept for investors, analysts, and business managers across various industries.

• Investment Analysis: Investors often analyze a company's economic operating leverage to understand its sensitivity to changes in economic conditions and sales volume. Companies with high operating leverage tend to be more cyclical, seeing large swings in net income during economic expansions and contractions. For example, a manufacturing company with significant investment in machinery and factories typically has high fixed costs, making its earnings more susceptible to changes in demand.¹⁰
• Strategic Planning: Business managers use operating leverage insights for strategic decisions, such as pricing strategies, production volume targets, and evaluating capital expenditures. A firm considering a large investment in automated production lines, for instance, must weigh the increased fixed costs (and thus higher operating leverage) against the potential for higher contribution margin per unit.
• Risk Management: Companies with high economic operating leverage face increased business risk. During periods of economic slowdown, their inability to easily reduce fixed costs can lead to substantial losses. This is particularly relevant for businesses that rely on consistent high sales volumes to cover their substantial fixed expenses. The U.S. Securities and Exchange Commission (SEC) EDGAR database provides public access to corporate filings, allowing investors and analysts to research a company's financial information and operations, including insights into their cost structures.⁵, ⁶, ⁷, ⁸, ⁹

Limitations and Criticisms

While economic operating leverage is a valuable analytical tool, it has certain limitations and criticisms:

• Simplistic Cost Classification: The clear distinction between fixed costs and variable costs can be an oversimplification in practice. Many costs have both fixed and variable components (e.g., semi-variable costs), or they may be fixed only within a certain range of production. For instance, administrative salaries might be fixed up to a certain level of activity, after which more staff may be needed.
• Static Nature: The Degree of Operating Leverage (DOL) calculation is a static measure based on a specific period's financial data. It does not account for changes in the cost structure over time or a company's ability to adjust its fixed costs in the long run.
• Focus on Operating Income: Economic operating leverage focuses solely on the impact of sales on operating income, neglecting the effects of financial costs (like interest expense) and taxes, which are factored into net income.
• Ignores Scale and Industry Differences: What constitutes high or low operating leverage can vary significantly by industry. A capital-intensive industry, such as automotive manufacturing, will naturally have higher fixed costs than a service-based business. Therefore, comparisons should ideally be made within the same industry or among companies with similar capital structure characteristics. High operating leverage can lead to greater volatility in earnings and share prices, especially during economic downturns. Academic research has also explored the implications of fixed costs on firm pricing and optimal supply chain design, noting that these costs can affect prices even when sunk and significantly impact network design.³, ⁴

Economic Operating Leverage vs. Financial Leverage

Economic operating leverage and financial leverage are two distinct but related concepts, both dealing with how a company's cost structure or capital structure can amplify returns or losses.

While economic operating leverage focuses on the top half of the income statement (sales to EBIT), financial leverage focuses on the lower half (EBIT to net income). Both types of leverage affect a company's overall risk profile and can lead to magnified returns or losses for shareholders.² Research indicates that firms with higher financial leverage tend to experience larger employment losses during economic downturns.¹

FAQs

What does high economic operating leverage mean for a company's profits?

High economic operating leverage means that a company has a significant portion of its total costs tied up in fixed costs. This can lead to rapid increases in profits once sales exceed the break-even point, as each additional sale only incurs minimal variable costs. However, if sales decline, profits can fall sharply because the fixed costs remain, creating a greater risk of losses.

How does economic operating leverage affect a company's risk?

Economic operating leverage directly impacts a company's business risk. Companies with high operating leverage are more vulnerable to fluctuations in sales. A small drop in revenue can lead to a substantial decrease in operating income, making them riskier during economic downturns or periods of unstable demand.

Can a company change its economic operating leverage?

Yes, a company can change its economic operating leverage by altering its cost structure. For example, investing in automation (replacing labor with machinery) would increase fixed costs and thus increase operating leverage. Conversely, outsourcing production or shifting to more flexible labor contracts could decrease fixed costs and lower operating leverage. These decisions are part of a company's long-term strategic planning.

Is high economic operating leverage always bad?

No, high economic operating leverage is not always bad. It can be highly beneficial in a growing market or during periods of strong sales. In such scenarios, the magnification effect of operating leverage allows companies to achieve significant increases in profitability without a proportional increase in costs. The key is to manage this leverage in alignment with the company's industry, market stability, and overall risk profile.