Two friends took their kids to an amusement park -- and ended up discussing concepts such as the operating leverage used by companies!
Rohan: Hey! Are you looking at that see-saw? I find it really interesting because even though my son is pushing its one end with slight force, the other end goes up with way higher force.
Jay: Yes, that happens due to the leverage provided by the fulcrum. But, this reminds me of another kind of leverage.
Rohan: Which leverage are you talking about?
Jay: I was thinking about Operating Leverage which can help companies amplify their operating income.
Rohan: What do these financial terms mean? Can you please explain?
Jay: Sure. Basically, operating income is the residual income left after operating expenses, such as raw material cost, salary, depreciation and other operating expenses, are deducted from the revenue. Operating leverage is like a fulcrum with the help of which a company’s operating income can increase by a much higher percentage even when there is only a small percentage rise in revenue.
Rohan: Okay, I have understood the concept but how can a company have operating leverage?
Jay: Let’s say, you have opened a small coffee shop. Firstly, you will have to incur some expenditure by renting a place, buying some coffee-making machines, grinders, etc., which costs you about ₹50 lakh a year (for simplicity assume the life of the equipment is one year and depreciated fully) . These costs are independent of how much sales you make in a year and hence these are your fixed costs. Then there’s cost on coffee beans, milk, cups, etc, , which depends on how many cups of coffee you sell in a year and so it is your variable cost. Let’s say each cup of coffee you sell costs you ₹10 in variable costs, and you are selling it at ₹100. Let’s also assume you have sold 1 lakh cups of coffee in a year and hence your revenue will be ₹1 crore and your total costs are ₹60 lakh (₹50 lakh of fixed cost and ₹10 lakh of variable costs). Hence your profits will be ₹40 lakh. .
But what if you have sold 1.2 lakh cups in the same year. Your revenue would be ₹1.2 crore while your profit would be ₹58 lakh (₹1.2 crore minus ₹12 lakh of variable costs and ₹50 lakh of fixed costs). Hence by generating just 20 per cent more revenue, you are generating 45 per cent more profit than what you would have gained in the previous scenario. Hence, the proportion of fixed costs to total costs can have higher impact on profits when there is a change in revenue.
Rohan: Oh! I never thought profits could rise in such fashion due to fixed costs. But how can I analyse public companies based on operating leverage as data categorised as variable costs and fixed costs aren’t available?
Jay: Yes, you’re right, such data isn’t explicitly available. You can try to identify the variable and fixed costs on your own or with the help of an accountant. Alternatively, we can assess rate of change in operating income to rate of change in revenue as I said initially.
Let’s take our home-grown steel company Tata Steel as an example. In 2022, the revenue of Tata Steel increased by 56 per cent YoY while its operating income jumped by more than 150 per cent for the same year.
Rohan: Okay, but why do we use operating profits and not gross profits?
Jay: We get gross profit by deducting cost of goods sold (raw material cost) from that. This cost is a variable one and usually moves up and down in tandem with revenue. While to get operating income, we need to deduct certain fixed costs that you will incur irrespective of change in revenue.
Rohan: Okay, I understood that operating leverage can boost a firm’s operating income when firm revenues are rising but what if it falls?
Jay: Operating leverage is a double-edged sword. It can surely boost your profit when revenues are rising but when revenues start falling, the operating income can plummet. This is because you have to incur the fixed costs even when revenue is low. For example, Tata Steel will have to incur depreciation and maintenance of its plant and machinery even when there is no production and plants are idle. Similarly there are rent and salary expenses that are fixed. This is the inherent risk with operating leverage that is faced by companies.
Rohan: Okay, so does this operating leverage impact all companies in this fashion?
Jay: No, operating leverage varies across sectors and business models. . Take the IT sector and consider HCL Tech, for example. Employee costs contribute most to the cost structure of HCL Technologies, and it is a variable cost due to which there can’t be much operating leverage in such firms. Hence, in case of HCL we can see that for 14 per cent increase in its revenue for the year 2022, there is no material change in operating margin and hence no operating leverage in play.
Rohan: Okay, so is it like operating leverage is more pronounced in companies involved in the business of automobile, airlines, utilities, etc, which have a high proportion of fixed cost present in their cost structure? .
Jay: Exactly! Now you’ve got it. When economy is booming, there is a possibility that companies having operating leverage may outperform those that don’t have it. But during a period of falling sales, companies with operating leverage might find their operating income/margins dropping drastically.