The power and pitfalls of operating leverage

Recently, Ultratech Cement , a prominent player in the cement industry, attributed its increase in operating margins to operating leverage. A 20 per cent increase in sales led to operating profit increasing by 42 per cent in Q4 FY23.

But what exactly is operating leverage?

Operating leverage measures how a company's profits react to changes in sales. Think of it like a seesaw: just like a seesaw tilts when one side is heavier than the other, a company's profits can also tilt based on how its costs (fixed and variable) and revenues are balanced.

Let us explain.

If a company has high fixed costs (a heavy side on the seesaw), it has high operating leverage. This can be good because when sales rise, profits soar faster because fixed costs remain constant. However, during periods when sales fall, profits can plummet by a greater magnitude as those fixed costs still need to be covered.

Conversely, if a company has more variable costs and fewer fixed costs (a light side on the seesaw), it has low operating leverage. In this case, profits move in tandem with sales growth because most of the costs are directly tied to how much the business sells.

This means, the higher the leverage, the higher the volatility of a company's profit, and vice-versa.

How is operating leverage calculated?

Operating leverage formula = Percentage change in operating profit (EBIT) / Percentage change in sales

For example, an operating leverage of two indicates that the operating profit will increase twice as much as the increase in sales.

The cons of operating leverage

Now, it may seem like a good thing for a company to have operating leverage since a small increase in sales will result in a considerable increase in profits. But the same can happen when there is a fall in the top line. A small drop in sales can amplify the fall in profits, thus making the overall results look bad.

Ultratech: Two sides of the coin

In Q4 FY23, Ultratech witnessed a 20 per cent increase in its sales. The effect on operating profit? A 42 per cent increase! That's more than double that of their top line growth. However, the opposite happened if we go back two quarters. In Q2 FY23, when its sales dropped by just 8 per cent, its operating profit fell by a whopping 40 per cent!

Your takeaway

Operating leverage is like a double-edged sword. On one hand, it can magnify profits during periods of growth. On the other hand, it can also magnify losses during periods of decline.

Although it is difficult to ascertain the exact operating leverage of a company (since companies don't disclose their per-unit variable costs), it is always a good exercise to check the proportion of fixed costs to the total costs.

Furthermore, companies in industries like construction and manufacturing entail higher fixed costs, which naturally leads to higher operating leverage. These companies, most of which are cyclical, may perform exceptionally well during a boom but will also be the most affected during a downturn. Thus, understanding the mechanics of operating leverage is of utmost importance before investing in such companies.

Also read: Why financial leverage is a double-edged sword