Financial and Operating Leverage - 2

In previous blog, we discussed Financial Leverage. And now, let’s talk about Operating Leverage.

Financial Leverage is to do with the Capital Structure of a firm, where as Operating Leverage is how that capital has been invested in the firm for its operations.

We know ‘Production Costs’ are broadly categorized as ‘Fixed Costs’ and ‘Variable Costs’. If a firm invests heavily in its PP&E (Property, Plant and Equipment), that is, in its fixed assets, it is increasing its ‘Fixed Costs’. Motivation for doing that is to be able to reduce ‘Variable Costs’.

Now, increase in ‘Fixed Costs’ gives firm the leverage to increase its sales and get magnified returns as compared to its competitors. Let’s see this with an example:

Example

There are 2 firms A and B. Firm A has invested heavily in its Fixed Assets and has higher Fixed Costs and lower Variable Costs as compared to another Firm B, in the same industry. Firm A has higher Operating Leverage as compared to Firm B.

Say, it is boom time and sales for both firms are 500 units each. Both have same Sales and sell at the same price. Yet, Firm A has higher Earnings than Firm B!!

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This is the magic of Operating Leverage working on Firm A’s side!!

Now the Risk Side

Again, we know higher returns are always associated with higher Risks. So what are the risks here?

Let’s go back to our example. Now, say, it is a slack time and sales for both firms have fallen to just 10 units. As seen in the figure below, Firm A with higher Operating Leverage is now making losses, whereas Form B is still showing positive earnings!
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Analysis
Other things same, with higher Operating Leverage, your point of breakeven sales would be higher as compared to a firm with lower Operating Leverage. For sales higher than the breakeven point, your gains will be higher. And for sales lower than the breakeven point your losses will be higher.