Operating Leverage

Every company has two basic kinds of costs: variable and fixed. Variable costs change with the number of items you produce. Each hamburger has a certain amount of meat in it. Make more hamburgers, use more meat. That's a variable cost.

Fixed costs remain constant no matter how many items you make. The rent on your hamburger stand is the same no matter how many hamburgers you sell. Your rent is $10,000 a month. It's $10,000 if you sell one hamburger. It's $10,000 if you sell a million hamburgers. The cost is fixed.

Operating leverage seeks to take advantage of the fixed nature of those fixed costs. Since they don't go up as production increases, you get a cost benefit from producing more stuff. Make one hamburger, that becomes an expensive burger. You'd better get at least $10,000 for it if you want to stay open. Because your production was so low, you spent $10,000 in rent just to sell that single burger. But sell a million burgers which means you're running a real fast-action hamburger stand...then your per-burger cost is much, much lower. The rent-cost for each burger drops to just a penny.

You spread the cost of that rent over a larger number of products, and the per-item cost of the products gets relatively smaller.

The impact of this appears on your financial statements as better operating margin. More of the revenue you bring in falls to the operating profit line. So operating leverage is great. But, unfortunately, not all companies are equally well positioned to take advantage. Some situations are friendlier to operating leverage than others. Specifically, operating leverage works best in situations with high gross margins and low variable expenses. Basically, the higher mix of your expenses come from the fixed category, the more room you have to take advantage of operating leverage.

Example time.

You found a company in your garage that makes windshield wipers. You think you've figured out a better way to push water off of glass, and you expect to become the Steve Jobs of the automatic squeegee industry. However, you find out quickly that you've entered a tough business. A lot of competition. Your design is 10% better than other products, but customers don't really seem to notice. You couldn't get financing, so you're making the wipers by hand in your garage.

You sell the wipers for $25 each...but between your labor and the supplies, each item has variable costs of $23 each. You get a $2 gross profit from each one. A measly 8% gross profit margin for each wiper. You're working out of your garage, stealing your neighbor's WiFi and selling your orders online. So your overhead costs are almost nil. Good news...kind of...in terms of your expenses. But taken together, your current business doesn't have much room for operating leverage.

The point of operating leverage is to spread the fixed costs of a business over a larger product base. Make more items and each item becomes comparably cheaper to make. In this case, that's almost impossible. The costs of your products come almost completely from variable expenses. Meaning that, if you make one wiper, it costs you $23. If you make two, it costs you $46. Make 100, it costs you $2,300. The total size of your costs change significantly as your output changes. You get no operating margin benefit from making additional products. So operating leverage doesn't get you anywhere.

Eventually, you give up. The wiper thing was a bad business...but you have a new idea. You're going to make luxury air fresheners for cars. You're going to have scents like "the Louvre warehouse when the Mona Lisa is getting cleaned" or "the deck of a yacht at sunset on the Adriatic" or "finding a million-dollar check in a sock drawer that you forgot you received."

Since you're targeting a luxury market, you can set your prices relatively high. Also, the product's themselves have very little variable costs involved. They don't take much labor to make: they consist only of a small bit of plastic and a spritz of smell-juice. Once you get the chemical compositions right for the fragrances, the actual production is very cheap.

Meanwhile, this time, you were able to find some investors, which means you don't have to work out of your garage. You build a factory...so you have higher fixed costs. But it also means that you can produce the items at scale. This setup represents a perfect situation to take advantage of some operating leverage.

You sell the fresheners for $4 each. They only take $0.79 to make a gross margin of just over 80%. The fixed costs of the factory are $2 million a month. You made 1 million fresheners in your first month. That's $790,000 in variable expense plus $2 million in fixed expense...$2.79 million in overall operating expenses for the month. On revenue of $4 million. Operating margins of 30.25%.

But you have a great opportunity to improve profitability by applying some operating leverage. Your factory has a capacity of 5 million units. Plenty of room to expand production. You double production in your second month. Now you make 2 million units. That increases your variable expenses to $1.58 million. But your fixed costs remain, well...fixed. They still come in at $2 million. Total operating expenses: $3.58 million. Total revenue: $8 million.

Those figures mean you had an operating profit of 55.25%. You increased your operating margin from just over 30% to just over 55% by doubling your production.

That increase represents the power of operating leverage. The more products you have to spread out your fixed expenses, the less expensive each one gets. However, it works best in a scenario with high gross margin and low variable costs.

So, in the right scenario, operating leverage can help a profitable company become mega-profitable. Maybe you should consider a new luxury fragrance: "operating leverage on a dewy morning."