Operating leverage is the degree, measure, or formula that attempts to break-down the relationship between fixed and variable costs (Chen, 2019). The principle of operating leverage behaves in the following manner: it increases profitability and decreases optimal financial leverage because of a negative relationship between profitability and financial leverage is produced.
High Operating Leverage
With my experience with the Software industry, in general, these tend to have high operating leverage. There is a large upfront cost in development which contributes to the overall high fixed cost. However, they do not have to increase costs if they require generating more income. Thus, they benefit from a higher profit margin from each additional sale above their break-even point (McClure, 2019). Another industry I briefly worked in was Pharmaceutical, and they also tend to have high operating leverage. The R&D required to be able to create a drug is the difficult part. Once it is understood and put into production, creating additional drugs is very low cost and each sale past the break-even point incurs an incredible profit margin.
Low Operating Leverage
Two industries from my career with low operating leverage can be Retail or Consulting. For retail, additional labor and material are required for each new sale. Companies like Zara and Nike operate all over the world and excel due to the volume. These companies have a low-profit margin as they incur on-going costs for each new sale. Consulting companies bill labor hours to clients, and as such, each hour of work has a high fixed cost that is constant.
Company Example
A software company Tableau has high operating leverage. As their financials, history, and operating model dictates, they have a high proportion of its costs dedicated to fixed costs related to labor in software developers (Tableau Software Inc, n.d.). Variable costs are minimized. They can offer clients software contracts that significant profit margins at retail price. New client sales do not affect their product and no additional costs are incurred for these new sales outside of the cost of sales, which is variable (travel, hours spent on account, support labor). Two activities Tableau can do to increase profit margins are to:
(1) Bundle software offerings together to close a sale that might not close or up-sell an existing account. Closing risky sales and up-selling an additional software solution by bundling solutions and charging a higher price are excellent ways to increase margins on a particular transaction.
(2) Sell existing solutions with fewer features for a lower cost. Since the software solution is already created, a few security changes can allow for Tableau to sell some of the same products that they already sell at a cheaper price to those who do not need all the features. A lot number of small to medium-sized businesses are unable to afford the Tableau licensing cost and turn to some of the more cost-effective competitors.
Resources
Chen, Z., Harford, J., & Kamara, A. (2019). Operating Leverage, Profitability, and Capital Structure. Journal of Financial & Quantitative Analysis, 54(1), 369–392.
McClure, B. (2019, July 10). How Operating Leverage Can Impact a Business. Retrieved from https://www.investopedia.com/articles/stocks/06/opleverage.asp
Tableau Software Inc (DATA.N) Company Profile. (n.d.). Retrieved from https://www.reuters.com/finance/stocks/company-profile/DATA.N
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