Thread by @money_theory

A thread on operating leverage:

High operating leverage makes profits surge in a booming market and plunge in a falling market for a business.

Today I will try to explain it in a simple way. Grab a glass of immunity drink and let's get started.

Before moving on, get a sense of these two terms

Variable costs: These costs change in proportion to production output/revenues

Eg: Raw material cost

Fixed costs: As the name says, these costs are fixed

Eg: Rent

Going back to the thread

Say, you run a business which manufactures steel. You made an income of 10 lakhs for the year. Variable costs are 2 lakhs, Fixed costs are 6 lakhs. You earned an operating profit of 2 lakhs.

You are content with your business performance.

And next year, for some reason, the steel industry has grown pretty well.

You made an income of 15 lakhs. Variable costs are 3 lakhs, fixed costs are 6 lakhs taking your operating profit all the way up to 6 lakhs (200%⬆️)

You are pretty happy now with your business.

Moving forward to the next year, suddenly a pandemic has come from nowhere and brought recession everywhere.

You made an income of only 5 lakhs. The variable costs are 1 lakh. However, with fixed costs being the same, you made an operating loss of 2 lakhs (200%⬇️)

Financial trouble has come to you and you are very sad about it.

Now, take a moment to think why has the massive profit-making business turned into a loss one all of a sudden. The answer lies in high operating leverage.

Operating leverage lets you know how a change in the business revenues will impact operating profits.

Though there are many formulae, the most practical one is below

Degree of operating leverage= % change in operating profits / % change in sales

Applying the formula to the above cases, you get the operating leverage of 4 times.

It means for every 1 percent change in sales, your operating profit changes by 4 percent

As you can observe,

In the first case, sales have grown by 50% whereas operating profits grown by 200%

In the second case, sales have declined by 50% turning operating profits into losses with a massive decline of 200%

You have just witnessed operating leverage in action.

Generally speaking, a company with high gross margins and low variable costs will have high operating leverage and vice versa

To give you some real-life examples

An airline company like indigo will have high operating leverage because it has high fixed costs.

A retail store business like Dmart will have low operating leverage because it has low fixed costs.

To conclude, high operating leverage is a double-edged sword. Be cautious when investing in such a business especially during a recession.

Thats it folks. Like and retweet if u find the thread value-added. Enjoy your weekend.

Hope u will have a look at the thread.
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