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Operating leverage has been one of the most talked about topics in some of the industries and the thread attempts to discuss some of the important drivers for changes in earnings due to operating leverage.

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Operating leverage can come in from better volumes (higher margin due to scale), better product mix and lowered costs.

1.The easiest way to think about operating leverage is as the ratio of fixed to variable costs. Higher fixed costs upfront means higher room for operating..
..leverage when sales increase. For e.g. for two firms with $10 mn sales and 20% margins but different fixed costs, margins will be different at higher sales – at $25 mn sales, firm with 75% fixed costs will have margins of 60% compared to ~30% for a firm with 25% fixed costs
2. The basic idea is that companies with high fixed costs to total cost have opportunity to generate higher margins through Op Leverage. There can be other ways as well – Lower opex costs as sales grows lead to higher margins – Think chemicals for 1st case, consumers for 2nd.
3. Key drivers for operating leverage then becomes – Sales growth (limited by industry growth), M&A growth (Not very high success rates), changes in a company’s market share, ratio of fixed costs to variable costs...
...(deviating from the paper from where this thread is inspired in terms of replacing costs from assets) and other cost efficiencies.
4. Financial leverage will also impact margins with companies having higher interest payments benefiting the most from sales growth – Net margins will increase by higher amounts given fixed nature of interests costs.
5.So what are the key questions to look at while evaluating operating leverage? Some of them will be

a. Did you consider the relevant macroeconomic variables and their impact on sales growth rates?
b. Do you understand the breakdown between the company’s fixed & variable costs? Include salary and employee costs here as well, not just asset costs
c. Have you analyzed which value factors have been relevant in determining past results & which will come into play for future
d. Did you determine the impact of cost efficiencies?
e. Have you calculated the operating margin beta for past results and estimated it to make a thoughtful forecast?
f. Did you analyze the balance sheet, including total debt and cash balances, to gauge the effect of financial leverage?
6. The other questions would then be – What is the incremental margin on new sales that a company needs to earn given the incremental fixed and working capital costs with respect to a specific cost of capital? The attached formula helps.
7. And what would be the breakeven margins for overall increased sales? The other interesting part is will the growth at these breakeven margins be value accretive? And when does it start becoming value accretive? In general, the incremental RoC must be higher than CoC.
8. A lot of these characteristics are defined by the industry a company operates in and do look a the broad industry characteristics while analyzing/estimating earnings change due to Op Leverage since how different is that estimate will define how the returns will be.
9. Basis for the discussion is a paper by Michael Mauboussin titled “Operating Leverage – A framework for anticipating changes in earning.” Do read this for a more detailed understanding.
10. So some of the sectors which merits deeper look in light of these would be Chemicals (high upfront costs, opex leverage later on). Also, software companies which upfront their people costs and employee costs as % of sales keeps on declining. Also, something like logistics.
Also, look out for for deleveraging in same industries where there's a degwroth. Situation can go from bad to worse very fast with falling margins and consistent fixed costs.
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