Operating Leverage

Small changes in individual performances leading to massive changes in

results, is termed as the concept of leverage. Archimedes, was one of the
most famous mathematicians in Ancient Greece, once said “Give me a
lever long enough and a fulcrum on which to place it, and I shall move
the world.”

Similarly, this concept of leverage can be applied to businesses. When

small changes in operations and efficiency lead to disproportionate
impact on margins and operating profits, this is what we call‘operating
leverage.

Suppose, you own a manufacturing business (think of chemicals,

pharma or textile). One of the hallmarks of a manufacturing business is
to spend before the products start generating revenues. Once you spend
before your manufacturing plant starts generating revenues, this often
leads to preproduction costs. Think of a factory that is completely ready
but isn’t generating revenues yet, as it is being audited by its customers.
However, the factory will still have to pay for the salaries of its
employees, the electricity costs, rent costs, and other miscellaneous
costs that are involved in the day-to-day operations. This is what we call
‘pre-production costs,’ as costs are being incurred before the production
starts
Now let's assume that your factory is up and running after getting
customer approvals. In the first year of business, your business has done
sales close to Rs.1 crore and your operating profit is at Rs. 20 lakhs.
Thus, your operating expenses are close to Rs. 80 lakhs. Out of these
operating expenses, pre-production costs are fixed at Rs. 24 lakhs. While
other operating expenses are Rs. 56 lakhs that is almost 56% of the sales
(Rs. 56 lakhs as a % of Rs. 1 crore). Effectively your operating margin is
at 20%.

Now your sales increase by 40% in the next year, whereas your pre-
production costs stay at Rs. 24 lakhs and the other operating expenses
remain at 56% of the sales. This is how the operating margins will look
like. Before you read further, I will ask you to stop and think about the
impact of what happens when sales increase and the operating expenses
remain fixed?

Think about what will happen to the margins?

Think about why it will happen?
Think about what is the key driver of operating leverage that is kicking
in?

This is what happens in the second year of the business, sales increase
by 40% and reach close to Rs. 1.4 crore. Pre-production expenses
remain the same at Rs. 24 lakhs and the operating expenses which are
close to 56% of sales are at Rs. 78.4 lakhs. Now let’s see what happens
to the margins:
Sales - Operating Costs = Operating Profit
1,40,00,000 - 1,02,40,000 = Rs.37,60,000 (37.6 lakhs)
Now, my operating profit margin expands effectively to 26.8%.
Similarly, my capacity utilisation (no. of units I can produce) hits close
to 100%, and at 100% utilisation, your sales grow further by 40%.
Notice how your operating margins keep expanding with the growth in
sales:

This is effectively what we call the concept of operating leverage.

Before I proceed, just ask yourself what are the most common elements
that are leading to such expansion in the operating margins?

These are the 4 common properties of operating leverage:

1. As a rule of thumb, higher the fixed costs higher would the operating
leverage be in a business.
2. The key determinant of operating leverage is sales growth. Thus,
small improvements in sales leading to disproportionate outcomes in the
margins.
3. Degree or how much operating leverage is built into a business can be
calculated as:
% Change in EBIT
%Change in Sales
4. Operating leverage also works in reverse if a business experiences
declining sales, this often leads to contraction in margins.

Vaibhav Global
Vaibhav Global, is a vertically integrated E-commerce business which
has significant operating leverage built into its business model. Close to
60% of the costs are fixed, which is spent on employees and other costs
(majority on TV carriage & web marketing). Let’s see what has
happened to the operating margins, EBIT and the sales since 2016. Since
2016 sales have nearly doubled. Whereas, the operating profit has
almost multiplied by 7x. This is the power of operating leverage.
Example: Laurus Labs
Both the gross margins expanded in Laurus due to forward integration
and the operating margins expanded when the pre-production costs were
spread over higher sales. This led to super fast earnings and ROCE
Expansion.