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Operating leverage is a double-edged sword

Causing profits to increase and decrease sharply with respect to sales, operating leverage can cut both ways

Operating leverage is a double-edged sword

Recently, Hero Motocorp and Eicher Motors, two of India's largest automobile manufacturers, blamed weak operating leverage for a fall in their operating margins. So what's operating leverage?

Simply stated, operating leverage measures the degree to which a firm or a project can increase its operating income by increasing its revenues. It is used to quantify a company's operating risk. This risk arises due to the structure of fixed and variable costs. A company with high operating leverage has proportionately higher fixed costs on account of land, buildings, plant and machinery. Once these costs are taken care of, any increase in sales can quickly translate into profits. However, if sales fall, the reverse is also true.

On the other hand, low operating leverage indicates that a company's variable costs, such as employee expenses, advertisements and promotions, are larger in proportion. This implies that a significant increase in the company's sales will generally not lead to a substantial increase in its operating income.

Investors should compare operating leverage between companies in the same industry as some industries have higher fixed costs than others. For example, manufacturing firms have a higher proportion of fixed costs, whereas services companies generally have a higher proportion of variable costs.

By paying close attention to operating leverage, a company's profitability can be forecast if the sales are ascertained reasonably. However, locating a company's operating leverage is not easy. Since companies are not required to disclose their per-unit variable cost, operating leverage is just an educated guess. Also, a company's pricing, product mix and input costs are subject to change every year.

Here are some companies with high operating leverage (more than three) in the last three years. As a result, their profits are prone to fluctuations.