Simply put: operating leverage – The Hindu BusinessLine

Two friends took their kids to an amusement park and ended up discussing concepts such as operating leverage used by corporations!

Rohan: Hey! Are you watching this swing? I find it really interesting because even though my son pushes one end with a slight force, the other end goes up with a much higher force.

Jay: Yes, this happens due to the leverage provided by the pivot. But it reminds me of another type of leverage.

Rohan: What leverage are you talking about?

Jay: I was thinking about operating leverage that can help companies boost their operating income.

Rohan: What do these financial terms mean? Can you please explain?

Jay: Sure. Basically, operating profit is the residual income that remains after operating expenses, such as raw material cost, salaries, depreciation, and other operating expenses, have been deducted from revenue. Operating leverage is like a fulcrum with the help of which the operating profit of a business can increase by a much higher percentage, even when there is only a small percentage of it. increase in income.

Rohan: Ok, I understand the concept but how can a company have operational leverage?

Jay: Let’s say you opened a small cafe. First, you will have to incur expenses by renting accommodation, buying coffee machines, grinders, etc., which costs you around ₹50 lakh per year (for simplicity, assume the lifetime of the equipment is one year old and fully depreciated). These costs are independent of the amount of sales you make in a year and are therefore your fixed costs. Then there is the cost of coffee beans, milk, cups, etc., which depends on how many cups of coffee you sell per year and so this is your variable cost. Say each cup of coffee you sell costs you ₹10 in variable costs and you sell it for ₹100. Also suppose you sold 1 lakh cups of coffee in a year and hence your revenue will be ₹1 crore and your total costs will be ₹60 lakh (₹50 lakh fixed cost and ₹10 lakh variable cost) . Hence, your profits will be ₹40 lakh. .

But what if you sold 1.2 lakh cups in the same year. Your income would be ₹1.2 crore while your profit would be ₹58 lakh (₹1.2 crore minus ₹12 lakh variable costs and ₹50 lakh fixed costs). So, by generating only 20% more revenue, you are generating 45% more profit than what you would have obtained in the previous scenario. Therefore, the proportion of fixed costs to total costs may have a greater impact on profits when revenues vary.

Rohan: Oh! I would never have thought that profits could increase in this way due to fixed costs. But how can I analyze SOEs by operating leverage when data categorized as variable costs and fixed costs is not available?

Jay: Yes, you are right, this data is not explicitly available. You can try to identify variable and fixed costs on your own or with the help of an accountant. Alternatively, we can assess the rate of change in operating profit against the rate of change in revenue, as I said at the outset.

Take the example of our local steel company, Tata Steel. In 2022, Tata Steel’s revenue grew 56% year-on-year, while its operating profit jumped more than 150% for the same year.

Rohan: Ok, but why do we use operating profits and not gross profits?

Jay: We get gross profit by deducting the cost of goods sold (cost of raw materials) from it. This cost is variable and generally evolves in parallel with income. Whereas to get operating income, we have to deduct some fixed costs that you will incur regardless of how the income changes.

Rohan: Ok, I understood that operating leverage can increase a company’s operating profit when the company’s revenue increases, but what if it decreases?

Jay: Operating leverage is a double-edged sword. It can certainly increase your profits when revenue increases, but when revenue starts to decline, operating profit can drop. Indeed, you have to bear the fixed costs even when the income is low. For example, Tata Steel will have to bear the depreciation and maintenance of its factory and machinery even when there is no production and the factories are idle. Similarly, there are rent and salary expenses that are fixed. This is the risk inherent in operating leverage faced by companies.

Rohan: Okay, so does this leverage impact all businesses in this way?

Jay: No, operating leverage varies across industries and business models. . Take the IT sector and consider HCL Tech, for example. Labor costs contribute the most to the cost structure of HCL Technologies, and it is a variable cost due to which there cannot be much operating leverage in these companies. Therefore, in the case of HCL, we can see that for a 14% increase in its revenue for the year 2022, there is no significant change in operating margin and therefore no leverage. in-game operation.

Rohan: Okay, is it like operating leverage is more pronounced in companies involved in automotive, airlines, utilities, etc., which have a high proportion fixed costs present in their cost structure? .

Jay: Exactly! Now you have it. When the economy is booming, companies with operating leverage may outperform those without. But during a period of declining sales, companies with operating leverage could see their operating profit/margins drop drastically.

Published on

May 21, 2022

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