A look at operating leverage

The following article is adapted from Motley Fool Million Dollar Wallet.

When I make my biannual pilgrimage to our Wholesale Costco (Nasdaq: COT), I’m like a kid in a candy store. A recent trip was no different; I filled my basket with a huge box of Rice Krispies goodies and enough Advil to survive the next bear market. While I dread crowds and queues, I’m no doubt pleasantly surprised at how easily the dedicated staff put me on the right track. This efficiency is one of the many reasons I think Costco is one of the best-run companies in the United States. There’s a lot to be learned by looking at how the businesses we own are run – so read on for my take on a metric that different businesses benefit in very different ways.

How operating leverage moves a business
Do you know what your favorite business’s cost structure looks like or why it matters?

Understanding the relationship between fixed and variable costs is an important part of determining a company’s operating leverage – how changes in sales, relative to a company’s cost structure, can fuel (or deflate) ) the company. We care about operating leverage here at MDP because it makes a big difference in a company’s earning power and in the potential growth of free cash flow, especially as the health of the global economy changes. But before we delve deeper into this important metric, let’s take a step back and define our terms:

  • Fixed costs: Often referred to as overhead, these include things like lease payments on factories and executive salaries – basically, expenses that don’t change even if production or sales change.
  • Variable costs: These expenses to do change as the sales activity changes. Think about the raw materials, packaging, and hourly labor directly involved in making or selling products.
  • Operating lever: It is the relationship between the fixed and variable costs of a business. The higher a company’s fixed costs relative to its variable costs, the higher its operating leverage.

Retailers and labor-intensive industries such as restaurants and accountancy firms have low operating leverage, while technology companies, utilities, and airlines have high operating leverage . Let’s look at two examples MDP that members know to illustrate how operating leverage can affect a business.

High operational leverage: IPG Photonics

If a business has high operating leverage, that means it can make more money from each additional sale. When a business’s cost structure is largely based on fixed costs, it doesn’t need to spend extra dollars when a new lead comes along or a current customer increases their order. The company already has the necessary assets, such as manufacturing facilities, equipment, and those well-paid executives, so it doesn’t need to spend tons of money to meet the growing demand. These savings help to increase the profit margin and profits grow faster than sales. But there are risks. Fixed costs have to be paid whether or not the business is booming. So when sales are struggling, margins and profits deteriorate quickly.

A perfect example of a company with high fixed costs and high operating leverage is Charter Portfolio holding IPG Photonics (Nasdaq: IPGP). As his colleague MDPer David Meier wrote in his discussion board post [Editor’s note: subscription required] On the company’s remarkable second quarter (more details below), “The dramatic increases were a function of the turnaround in sales and the nature of IPGP’s business model. A vertically integrated company can generate incredible returns if it is properly sized. But if sales are too light, high fixed costs eat away at margins, which happened during the 2008-2009 crisis. Fortunately for us, IPG is benefiting from increased sales, and in Due to its fixed cost structure, this results in a significant increase in margins and cash flow.

Low operating leverage: Costco
On the other hand, companies with low operating leverage have variable cost structures, which positions them better to do well when times are tough. Variable costs decrease when the economy is struggling, and businesses without the burden of high fixed costs can be nimble and adapt faster. This can allow a business to make profit even when it generates less income.

A good example is my favorite supplier of Rice Krispies goodies, Costco. Inventory and part-time labor make up a large part of its cost structure. When times are good, Costco will spend more on inventory, filling its shelves with a ton of merchandise. It will also attract more part-time workers. But if things turn a little south, Costco can lighten their inventory and cut most of their manpower hours, helping the business continue to generate profits.

Crazy result
To sum up, there are three things to keep in mind when considering the operating leverage of a potential investment:

  • Companies with fixed cost structures benefit from a rapid increase in their margins and profits when there is an increase in sales.
  • Businesses with variable cost structures can make money with lower sales, but they have less benefit to their margins.
  • In times of economic downturn, variable cost structures help businesses cut costs quickly.

Ron Gross (TMFGreedandFear)

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.

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