Operating Leverage is defined as the effect of little change in the sales on the returns on equity. It means that the small decline in the sales results in the large decline in the ROE (in case the sales are below breakeven point). The formula of operating leverage is as follow
Operating Leverage = Fixed Costs / Total Costs
The higher operating leverage shows higher proportion of fixed costs which results in the increasing of risk. There are a number of industries that shows higher operating leverage like
- Capital Intensive Industries (Cement, Power Plant, Textile Spinning, Steel etc)
- Research & Development High Cost Industries (Auto, Pharmacy etc)
- New Product Development
- Industries requiring skilled & highly specialized workers (Software House, Information Technology, Semiconductor & Microprocessor etc)
In order to clarify the sensitive effect of change in sales over ROE, some terms needs to be cleared first.
Return on Equity (ROE):
The measure of entire return of the organization is referred to as return on equity. When an organization has 100% equity in its capital structure then the entire return of the organization is Return on Equity and any variation in ROE is the measure of risk for that organization.
Operating Leverage Break Even Point
The amount of sales at which operating revenues completely equal the operating costs is the break-even point. Also breakeven is that point at which the EBIT (Earnings before Interest & Taxes) = 0.
EBIT = Operating Revenue – Operating Costs
From accounting perspective operating costs are combination of fixed costs & variable costs. So
EBIT = Operating Revenue – Fixed Costs – Variable Costs
EBIT = (PQ) – (VQ) – F
Q = Quantity or No. of units sold of product
P = Product Price (Rs)
V = Variable Cost of product per unit (Rs)
F = Fixed Costs
Operating Revenue = Product price x No. of units sold of product
Variable Costs = Variable Cost of product per unit x No. of units sold of product
It is obvious that at break-even point
EBIT = 0
Also it is stated before that
EBIT = (PQ) – (VQ) – F
EBIT = (PQ) – (VQ) – F = 0
By solving the above equation we get
Q = F / (P – V)
The above derived equation shows the minimum No. of units that the organization should sell in order to equal its operating costs. It is clear that the change in sales has drastic effects similarly change in break-even will also have great effects.
The following diagram depicts the sensitive effect of little change in sales over ROE.
The operating leverage is graphed in the above diagram. The sales quantity in No. of units is represented on x-axis while revenues & costs (Rs) are represented on y-axis. The line that originates from the origin shows sales revenue (PQ). There are two cost lines drawn representing different technology. The cost line of technology A is higher one which represents higher operating leverage. Technology B cost line is lower but its slope is higher. The above mentioned graph provides two important points.
01- The technology A has higher fixed costs which represents higher operating leverage supposing that the lines on the graph corresponds to total costs of the technologies. The technology A has higher operating leverage and its effect on EBIT is that it has higher operating loss which is shown by the left hand side of the graph. This loss is resulted from the higher total costs instead of sales revenue. The organization that has higher operational leverage corresponds to its higher percentage of fixed costs. The organization that has higher percentage of fixed costs has high risk for operational losses irrespective of the higher or lower sales. That is the reason for consideration of certain businesses, companies, technologies and projects with higher operating leverages as much risky ones having more chances to bear operational losses because of their higher fixed costs which are unavoidable. Higher operating leverage exhibits larger reduction in EBIT as shown in graph.
02- The break-even point also increases with the increase in operating leverage by shifting to the right. In simple words, the organizations that have higher operating leverage needs more units to be sold to compensate their operating losses.
The above mentioned two points describe the ways through which the operating leverage influences the risk level of organization. It is clear that operating leverage affects the EBIT. When operating leverage is higher there are higher chances for drastic falling of ROE. Therefore the riskiness of the organizations is higher with higher operating leverage. Also the discount rate of Net Present Value is higher, the required rate of return is higher and calculated NPV for investment decision is lower.
Application of Operating Leverage (OL) to Capital Structure:
The capital structure of a company is also affected by the operating leverage. Those companies that have higher operating leverage are more risky and this points outs to the following facts about the companies
- These Companies have higher Betas (related with the Cost of Capital approach of CAPM approach)
- Their weighted average cost of capital is higher
- The overall rate of return in terms of ROE is also higher for these companies under the condition that their sales are higher than the break-even point. Resultantly the companies earn higher EBIT by having higher operating leverage.
The overall effect of operating leverage take into account both higher risk & higher return for those companies that have higher operating leverages. Following graph shows the impact of operating leverage on risk & return of particular company.
On x-axis ROE is graphed while on y-axis probability is shown. Two probability distributions are shown one on the left side with tall & sharp peak that corresponds to technology B having lower operating leverage. The risk & average ROE for technology B is lower. The technology A is represented on the right side of the graph with lower peak & flat shape having higher operating leverage. The risk & average ROE is higher. The WACC is also higher for technology A with higher required rate of return.