📊 Costs (Part 2)

Understanding operating leverage

Hi everyone, and welcome to our new joiners!

This is part 2 of 3 of my breakdown on costs. If you haven’t read part 1, you can find it here.

Now that you understand the difference between variable costs & fixed costs, let’s see how the mix of both can impact a business.

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Quick Recap from Last Post

In my last post, I’ve explained the concept of a Cost Structure, and went over the difference between Fixed and Variable costs.

Variable Costs

Costs per unit are fixed, and total variable costs go up with production level.

Fixed Costs

Total costs stay fixed, and costs per unit decreases as production rises.

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Operating Leverage

Now let’s dive into the new concept.

Having fixed costs creates something quite interesting in a business: it decreases the cost per unit when production is high, but make the company incur the same amount of costs even when production is low.

Having high fixed costs generates some operating risks for a business:

When a business is performing well, its total cost per unit decreases, but when a business isn’t going well, its total cost per unit will increase.

The key idea here is to understand that when a business with high fixed costs produces and sells more units, it benefits from lower costs per units.

As business analysts, we are interested in understanding how a change in revenue will impact our margins, as we ultimately want to maximize our operating margins.

We can quantify this relationship between revenue and operating income with the Degree of Operating Leverage (DOL).

Degree of Operating Leverage

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To measure the DOL, we look at how much operating income changed compared to a change in revenue.

Think about this for a second.

This means that operating income will not grow at the same rate as revenue if your business has fixed costs. The higher the fixed costs, the more your operating income will grow compared to your revenue growth.

If your business’ costs were fully variable, then its operating income would grow at the same rate as its revenue.

This is why having FC creates leverage in a business. You can expand your margin by changing your cost structure and having a higher proportion of FC to total costs.

Operating leverage can also be defined as the capability of the firm to use its fixed costs to generate better returns.

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How to think about this

This concept is powerful and you should think about it anytime you are forecasting a company’s financials.

If you expect revenue to grow by 10% for the next 5 years, then depending on the cost structure, your EBITDA will potentially grow by more than 10%, which has a direct impact on the value of the business.

You should also keep in mind that the reverse is also true. If revenues decline by 10%, then your EBITDA will decline by more than 10% if the operating leverage is high.

Another way to think about this is that the DOL provides a measure of a company's earnings volatility and can be used to compare companies. In periods of uncertainty, companies with high FC may be more at risk, as they have lots of costs just to keep the business running, even when production is low.

This was part 2 of 3 on my posts on costs. My next post, will cover the idea of contribution margin.

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