Operating leverage is a large component of business risk and is defined by Investopedia as the process by which the revenue generated from additional sales exceeds incremental costs. When businesses engage in operating leverage, they are increasing their efficiency ratio by having little to no variable costs associated with production or services. Risks associated with increased sales can be offset by management actions that have very minimal effects on balance sheet items such as assets and equity. Operating leverage should not be confused with financial leverage, a concept that defines a company’s ability to finance its assets through debt rather than equity.
Operating Leverage Explained by Aron Govil
As an example of operating leverage at work, consider a publicly-traded grocery store chain experiencing significant growth across its total number of locations. As the company is able to regularly increase revenue at each location, costs associated with labor and supplies will also rise.
Thanks to operating leverage, however, the incremental costs of each additional sale are de minimus in relation to company-wide profits. If grocery store A doubles its number of locations within a year, it would stand to reason that operating expenses would roughly double as well. The total cost for rent, utilities, and other regularly incurred expenses (at least on an aggregate basis) does not change dramatically when new stores open up. As long as total revenue outweighs these fixed costs per location, the company remains profitable throughout this growth spurt irrespective of whether individual margins are high or low. Operating leverage can best be compared with an adjustable interest rate loan, where the rate of interest is based on a set payment schedule.
As operating leverage becomes more prevalent within a company, it has the potential to increase profits at an accelerated rate. For example, if one restaurant location doubles its revenue in a given year there’s less pressure on incremental costs relative to results generated across an entire chain of eateries. You can best understand operating leverage as “added” sales resulting in massively positive effects on net income without being bogged down by increased expenses. Operating leverage also allows companies to better withstand tough economic climates by maintaining consistent margins.
When Does Operating Leverage Work Against Businesses?
Aron Govil says If you use our grocery store analogy again but assume that revenue growth outpaces incremental cost increases over the years, the grocery store chain is in danger of falling into the trap of negative operating leverage. This situation often occurs when companies are not able to maintain a consistent revenue stream across a growing number of locations. If costs increase faster than sales, businesses can quickly become less profitable and cash-flow positive.
Operating leverage can work against a business in several ways:
Increased expenses associated with rapid expansion:
The company keeps adding new stores but increases its spending on advertising and promotions each time it opens up another location. As costs begin to rise without the corresponding benefit of increased consumer traffic, margins across the entire chain will get smaller.
Inventory inflation or purchasing issues:
A dramatic surge in demand for goods could lead to product shortages that reduce profits from an otherwise successful revenue stream. If the business is experiencing more customer traffic than it can handle while trying to keep merchandise in stock, operating costs will rise while revenues stay flat.
Lack of flexibility:
As an example, one grocery store chain that we spoke with recently told us that its margins were negatively affected by high employee turnover rates. Turnover is often higher when locations are experiencing significant growth within a short period of time, driving up associated labor costs at the same time as new operators make mistakes with their initial inventory and purchasing decisions.
How to Prevent Negative Operating Leverage
The best way for companies to avoid negative operating leverage is through balancing expansion plans with available cash flow. As long as sales continue to increase at a faster rate than operating costs, businesses will have a positive impact on net income. If a company can’t generate enough revenue to offset increased expenses, it’s probably time to slow down the rate of expansion or cut back on operating expenses across all locations rather than just a few.
A company can increase profits at a fast rate if operating expenses do not rise as quickly as sales. This is the magic scenario that every business executive wants to achieve, whether they’re dealing with one location or thousands of stores all over the world. Unfortunately for many executives, their employees and customers often won’t allow them to capitalize on this opportunity.