Lesson 2 of 7
Fixed costs and operating leverage
A business with heavy fixed costs turns a small change in sales into a much larger change in profit, in both directions.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Operating leverage is how much a change in sales magnifies into a change in profit.
- A high fixed, low variable cost business swings harder in both directions than a low fixed, high variable one.
- From the same starting point the magnification is symmetric: what makes a downturn worse also makes an upturn better.
Two businesses can earn the same profit at the same sales and still respond completely differently to a change in demand. The difference is how much of their cost is fixed rather than variable, and it is read straight off the income statement.
Profit of two businesses as sales move
- A, sales $900$50
- A, sales $1,000$100
- A, sales $1,100$150
- B, sales $900$80
- B, sales $1,000$100
- B, sales $1,100$120
The same profit at two different structures
Business A has fixed costs of $400 and variable costs of 50 percent of sales. Business B has fixed costs of $100 and variable costs of 80 percent of sales. At sales of $1,000 both earn a profit of $100. They look identical at one point and behave nothing alike everywhere else.
Fixed costs are the leverage
A fixed cost is paid whether the business sells one dollar or one million. Once it is covered, every further dollar of sales keeps its full contribution margin as profit. The higher the share of cost that is fixed, the more of each new sales dollar drops straight to the bottom line. That is why Business A's profit swings so much harder than Business B's on the same change in sales.
Degree of operating leverage equals Contribution (sales − variable costs) divided by Operating profit.
Example$500 ÷ $100 = 5x for A; $200 ÷ $100 = 2x for B
It runs the same way in reverse
The mechanism that adds profit on the way up subtracts it on the way down. A business with heavy fixed costs and a small revenue decline can see profit fall by a much larger percentage, or turn into a loss. The fixed costs still have to be paid out of a smaller contribution. Operating leverage has no preferred direction.
Where to read it in a filing
Item 7 of Form 10-K, management's discussion and analysis, is where a company explains what moved its cost structure, its volumes and its prices during the year. A company rarely states its fixed and variable split directly. A profit that moved by a much larger percentage than revenue did is usually the sign that a heavy fixed cost base is doing the work described above. The exception is a change that came from price, which MD&A usually splits out from volume.
Check yourself
Two businesses earn the same profit today. Which one is riskier if sales fall?
- The one with more variable cost
- The one with more fixed cost
- Neither, since their profit is equal
Show the answer
Answer: B.
A fall in sales leaves less contribution to pay the same fixed bill, so profit falls by a larger percentage.Operating leverage magnifies a change in sales into a larger change in what?
- Revenue
- Profit
- The number of units sold
Show the answer
Answer: B.
Operating leverage describes how a given percentage change in sales becomes a larger percentage change in profit, once fixed costs are in the mix.Does operating leverage help or hurt on the way down?
- It only ever helps
- It magnifies a fall in profit just as it magnifies a rise
- It has no effect once sales start falling
Show the answer
Answer: B.
The mechanism is symmetric. The same fixed costs that let profit rise faster than sales also make it fall faster than sales.Sources
- Item 7 of Form 10-K, management's discussion and analysis, where cost structure, volumes and prices are explained.
What this leaves out
- Both businesses in this lesson are round invented examples built to isolate one mechanism; no filing reports a fixed-variable split this cleanly.
- A real cost base mixes fixed and variable costs inside single line items and shifts over time as a company automates or outsources.
- Nothing here says which structure is better to own, or what any company is worth. Nothing here is advice about any security.