10.2 Operating Leverage
We have already studied “financial leverage,” which had to do with the (income statement) relationship between operating earnings (EBIT) on the one hand, and both net income (NI) and earnings per share (EPS) on the other hand. We saw how financial leverage also impacted return on equity (ROE). In short, we observed that financial leverage increases interest expense, resulting in lower net income. However, when operating income levels are sufficiently high, financial leverage serves to magnify both EPS and ROE. When operating levels are below a certain amount – the crossover point – both EPS and ROE are worse than they would be absent financial leverage.
Operating leverage, in contrast, modifies the relationship between sales and EBIT. Operating leverage has to do with management’s decision to invest – or not – in capital equipment in order to manufacture widgets, or, alternatively, to rely more on labor in the manufacturing process.
It has thus to do with the ratio of labor inputs versus capital inputs to the production process, or, put differently, fixed costs, representing capital investment, versus variable costs, representing the labor element. It is helpful to see the two types of leverage relationships in terms of the income statement.
| Income Statement For Year Ending 12.31.xx |
| Sales | Operating Leverage | |
| (Cost of Goods Sold) | ||
| Gross Profit | ||
| (S,G, & A) | ||
Financial Leverage |
EBIT | |
| (Interest) | ||
| (Taxes) | ||
| Net Income | ||
| Earnings Per Share | ||
| Return on Equity |
We shall see that, when output is sufficiently high, it shall behoove the company to employ operating leverage, i.e., to invest in productive capital equipment – with fixed costs that are independent of the level of production, and to rely less on labor or variable costs. In such instances of high output, operating profits (EBIT) will be greater, i.e., more leveraged, than would be the case had the company invested less in capital or not at all.
We shall also discover the precise “crossover point” at which the employment of operating leverage first becomes worthwhile. In the course of this analysis, we shall not distinguish between production and sales; we shall assume that all units produced shall generate revenues – all units will be sold and the firm maintains no inventory.