Operating Leverage: A Case Study
Consider two companies, Arkansas Best and Landstar Systems, both of which are classified as trucking companies. According to Landstar’s 10K filing for the year ended December 30, 2006 (p. 5), “The carrier segment markets its services primarily through independent commission sales agents and utilizes Business Capacity Owner Independent Contractors and Truck Brokerage Carriers. Using a stylized example:
Operating leverage is computed by dividing the contribution margin (revenues less variable costs) by the operating income. In this case, operating leverage is 1.50 (300/200). So, a 10% increase in revenues should yield a 15% increase in operating income (10% * 1.5). As seen above, a 20% increase in sales yielded a 30% increase in operating income. Since our example had no interest expense, there is no financial leverage and the increase in taxes and net income was also 30%.
The company benefits from operating leverage as it grows since fixed costs do not increase and existing fixed costs are “spread” across higher revenues. As a percentage of revenues, the fixed costs shrink. Of course operating leverage will also work against the firm if revenues fall since fixed costs do not fall accordingly. In fact, in our stylized example, if revenue were to fall by 20%, operating income would fall by 30%.
Operating leverage also does not remain constant; it must be recomputed each period as the relationships among contribution margin, fixed costs, and operating income change. This can be seen from the Arkansas Best example, where adding capacity caused the “fixed” costs to rise at a higher rate than revenues in 2006. It can be difficult even for someone inside the firm to accurately measure fixed costs versus variable costs. Statistical techniques such as regression analysis can be useful for this purpose. A shortcut method of approximating operating leverage is to divide the change in operating income by the change in sales:
(Percentage Change in Operating Income)/(Percentage Change in Revenues)
For Arkansas Best, if we assume that the change between 2004 and 2005 represents a “normal” level of operating leverage (in reality a longer data series would be needed) we can approximate the operating leverage as 8.2%/6.0% = 1.37 or 137%. A 10% increase (decrease) in sales would result in a 13.7% increase (decrease) in operating profit.
It is unrealistic to expect fixed costs to remain constant indefinitely. As the company grows, fixed costs may need to be increased periodically in a stepwise manner. For example, headquarters administrative costs might be fixed for a company’s current level of production and for small increases in production. However, if production were doubled, some of these fixed costs might increase.
For Arkansas Best, it wasn’t an actual increase in sales but planning for anticipated future increases that hurt margins in 2006. If we calculate the operating leverage from 2005 to 2006 we get 6.2%/9.5% = 0.65. Operating leverage less than 1.0 implies that profitability declines when sales increase. This is clearly not normal. In future years, the company’s profit margin should improve as sales grow into the new fixed costs. At some time in the future, though, the company will again reach a level of activity where fixed costs must increase, and the profit margin would generally be expected to decline in that year.
For more information, see all articles on: Common Size Analysis, Corporate Governance, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis See also:
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
