Operating Leverage – How it Affects Business
A phrase that you may see when researching any company or business for investment purposes is operating leverage. This is a term that refers to the measure of how revenue growth transforms into operating income growth. This statistic can measure leverage, and the measure of how risky a company’s operating income or cost structure can be. Some businesses are more efficient and smoothly operated than others, which can be one factor to consider for investors. When you are trying to determine which company to invest in, you may want to consider this facet.
One of the things that will determine a company’s operating leverage is the relationship between its fixed and variable costs, for example. This can include its changes in sales and cost structure. To get started with understanding more about this concept, it can be helpful to take a look at all the different types of costs out there. Fixed costs can include things such as lease payments, executive salaries, or other factors that don’t change along with other variables. Variable costs, on the other hand, are expenses that will change along with sales activity. This could include the cost of production, hourly labor, and packaging materials. As the demand for products goes up, these variable costs may increase as well.
The operating leverage, then, is the relationship between any business’s fixed and variable costs. If the business’s fixed costs are high compared to the variable costs, the operating leverage is also considered to be high. Industries that rely heavily on labor costs will have a low level of this leverage, while those such as tech companies and utilities will have higher leverage. These factors will influence how much profit a company is capable of making, which is of use to investors when researching businesses.
When you are looking at any operating leverage of a company that you are thinking about investing in, you should examine the fixed cost vs. variable cost of that business, on the other hand. Those companies that have fixed cost structures will have a high rise in profit when sales increase, while those with variable cost structures can still make money even if sales are low. However, there will be less of a rapid ascent in their profit margins. Yet when the economy takes a dip, those with a variable cost structure will be better able to cut costs quickly and weather any situation that comes their way, so they may be better long term prospects.