Operating Income

and finance Allah shmoop How does operating leverage work for

high margin versus low margin companies All right people While

every company has two basic kinds of costs variable and

fixed well variable cost change with the number of items

you produced each hamburger has a certain amount of meat

in it Make more hamburgers Use more meat That's a

variable cost Fixed costs remain constant No matter how many

items you make the rent on your hamburger stand is

the same No matter how many hamburgers yourself Like your

rents 10 grand a month it's 10 grand If you

sell one hamburger it's 10 grand If you sell 1,000,000

hamburgers the cost is fixed Operating leverage seeks to take

advantage of the fixed nature of those fixed costs Since

they don't go up as production increases like they're a

freebie you get a cost benefit from producing Mohr stuff

Make one hamburger and that becomes a very expensive hamburger

to produce Better get at least 10 grand for it

and change it if you want to keep the doors

open Therefore going bankrupt because your production was so low

you spent $10,000 in rent You asked to sell that

single hamburger But if you sell 1,000,000 burgers well then

your per burger cost of rent was much much lower

the rent cost And for each burger drops table just

a penny It's almost negligible You spread the cost of

that rent over a very large number of products and

the per item cost of the product gets relatively way

smaller Well the impact of this dynamic appears on your

financial statements as better operating margin mohr of the revenue

you produce falls to the operating profit line so operating

leverage is great But unfortunately not all companies are well

positioned to take advantage of it Some situations air friendlier

to operating leverage than others specifically operating Leverage works best

in situations with high gross margin unit products and low

variable expenses Like basically the higher mix of your expenses

that come from the fixed category Will the more room

you have to take advantage of operating leverage Alright let's

walk through an example Here you founded a company in

your garage that makes windshield wipers You think you've figured

out a better way to push water off of glass

and you expect to become the Steve Jobs of the

automatic squeegee industry However you quickly find out that you've

entered a tough business a lot of competition Your design

is 10% better than other products but customers don't really

care You couldn't get financing so you're making the wipers

by hand in your own garage You sell the wipers

for 25 bucks each but between your labour and the

supplies each item has variable cost of $23 each So

you only get a $2 gross profit from each sale

a measly 8% gross profit margin for each wiper sold

But you're working out of your garage stealing your neighbor's

WiFi and selling your orders online so your overhead costs

are almost nil Good news kind of in terms of

your expenses there But taken together your current business doesn't

have much room for operating leverage The point of operating

leverages has spread the fixed costs of a business over

a large product based make more items and each item

becomes comparably cheaper to make well In this case it's

almost impossible to do that the cost of your products

come almost completely from variable expenses meaning that if you

make one wiper cost you $23 If you make two

would cost you 46 make 100 Well then it cost

you $2300 The total size of your costs change significantly

as your output changes you get no operating margin benefit

from making additional products at scale So here operating leverage

doesn't get you well pretty much anywhere Eventually you give

up the white fur thing was a bad business But

you have a new idea You're going to make luxury

air fresheners Four cars Yes you're gonna have sense like

the luv warehouse when Mona Lisa is getting cleaned or

the deck of a yacht at sunset on the Adriatic

or finding $1,000,000 check in a sock drawer that you

forgot you received Since you're targeting a luxury market you

khun set your prices relatively high Also the products themselves

has very few variable costs involved like they don't take

much labor to make They consist only of a small

bit of plastic and a spritz of smell juice Once

you get the chemical composition right for the fragrances while

the actual production is very cheap Meanwhile this time you

were able to find some investors which means you don't

have to work out of your garage You build a

factory which means you have a higher fixed cost But

it also means that you can produce the items at

scale meaning thousands of them This setup represents a perfect

situation to take advantage of operating leverage Well guess what

You sell the freshness for four bucks each they only

cost 79 cents to make a gross margin of just

over 80% The fixed costs the factory well or $2,000,000

a month You made 1,000,000 fresheners in your first month

and that's $700,000 in variable expenses plus 2,000,000 in fixed

expenses or 2.7 9,000,000 in overall operating expenses for the

month And you sold all of them 100% At four

bucks We had revenue of $4,000,000 or operating margins of

30.25% But you have a great opportunity to improve profitability

by applying some operating leverage like your factory has capacity

to make 5,000,000 units a month plenty of room to

expand production Will you double production in your second month

and you make 2,000,000 units which increases your variable expenses

Toe 1.5 8,000,000 See there's the math but you're fixed

Costs remain well fixed They still come in at $2,000,000

right Total operating expenses then 3.5 8,000,000 total revenue 8,000,000

Because you sold him all those figures mean you had

operating profit of 55.25% You increased your operating margin from

just over 32 just over 55% by doubling your production

anyway that increase represents the power of operating leverage The

more products you have to spread out your fixed expenses

upon well the less expensive each unit gets to produce

However it works best in scenarios with high gross margin

and low variable cost products So in the right scenario

operating leverage can help a profitable company become mega profitable

Maybe you should consider a new luxury fragrance of operating

leverage on the doing Morning Yeah What I'm putting in

my car