Should we buy or rent the piece of equipment we need? Should we hire a full-time salaried employee or should we subcontract the work to an independent contractor? Business owners and managers often only answer these and other similar questions with the firm's financial leverage, meaning its use of debt and equity, in mind. Businesses should also consider another form of leverage which exists in every company - operating leverage. This leverage measures the firm's fixed versus variable expenses.
How is Operating Leverage Measured
If a company has high fixed costs and low variable costs, then it has a high degree of operating leverage (DOL). An example would be a law firm, because its main expenses (salaries, rent, and insurance) are fixed regardless of the sales volume it produces. A company with low fixed costs and high variable costs has a low DOL. An example would be a construction company in which most of its costs vary based entirely on sales volume (materials, subcontractors, and job-related labor). The companies in the example below have the same net income, but very different operating leverage:
Law Firm (High DOL) with sales of $1,000,000. Variable costs of $350,000, or 35%. Gross profit or contribution margin of $650,000, or 65%. Fixed costs of $450,000, or 45% of sales. Net income $200,000, or 20% of sales.
Construction Co.(Low DOL) with sales of $1,000,000. Variable costs of $700,000, or 70%. Gross profit or contribution margin of $300,000, or 30%. Fixed costs of $100,000, or 10% of sales. Net income of $200,000, or 20% of sales.
What Benefits and Risks are Associated with Operating Leverage?
Assuming sales increase 25% in both companies, let's see how the results compare:
Law Firm (High DOL) with sales that grow to $1,250,000. Variable costs of $437,500, or 35%. Gross profit or contribution margin of $812,500, or 65%. Fixed costs of $450,000, or 36% of sales. Net income $362,500, or 29% of sales. Profit growth of 81.3%.
Construction Co.(Low DOL) with sales that grow to $1,250,000. Variable costs of $875,000, or 70%. Gross profit or contribution margin of $375,000, or 30%. Fixed costs of $100,000, or 8% of sales. Net income of $275,000, or 22% of sales. Profit Growth of 37.5%
Clearly, the law firm experienced more profit growth than the construction company, even though their revenue growth was identical. This is the magnification effect that comes from operating leverage. Conversely, if the firm's revenues decreased, the law firm would experience a magnification of its negative profit growth, creating less net income than the construction company. Greater risk exists in firms with higher operating leverage, yet the potential for better returns could make that risk attractive.
How Does Operating Leverage Impact Your Business Decisions?
In order to assess the risk versus return scenario of your operating leverage in your business decisions, you need to ask yourself two questions: (1) Are you going to grow or shrink in the short and long-term? (2) What is your firm's tolerance for risk? All things being equal, a business that is going to grow would wisely invest into fixed costs instead of variable costs in order to magnify its profit during that growth. Conversely, a shrinking firm should look to minimize its fixed costs. It is no surprise that buying instead of renting equipment and hiring full-time labor instead of subcontracting work are more risky than the alternatives. Perhaps the most enlightening point is that with a little planning and foresight, the decision made could significantly help or protect the bottom-line.
Consider the following questions as you determine your firm's operating leverage strategy: How does your degree of operating leverage compare to your competitors'? What competitive advantages may or may not exist in your industry for the company with the highest degree of operating leverage? The strength and future success of your business model probably depends, in part, on how you utilize operating leverage. When correctly applied, the principles of operating leverage will allow you to maximally leverage your business without incurring additional debt.