How Does Operating Leverage Impact Corporate Profitability?

It's common to see headlines in newspapers highlighting significant fluctuations in companies' profits from one year to the next. But have you ever wondered what might be behind these expressive variations? Are they the result of inefficient management or unpredictable external factors?

The answer largely lies in the effects of operational leverage (structure of assets and costs) and financial leverage (capital structure). In this first article on the topic, we will explore how operational leverage can impact companies' profitability and earnings.

To introduce the concept in a more general way, it's worth mentioning that the preliminary concept of leverage comes from the meaning of "lever" in Physics, which relates to achieving a result that is greater than the effort employed.

To present the concept of Operational Leverage and explain it practically, let's use an example:

Suppose company X has fixed costs of R$50,000 per month and variable costs of R$25 per unit of merchandise sold. If the company sells 3,000 units per month at R$50 each, its revenue will be R$150,000. This results in a gross profit of R$75,000 = (R$150,000 - R$75,000), with a net profit of R$25,000, as shown in the calculation below.

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      Now, suppose the company increases its sales to 4,000 units per month (+33% increase in sales volume). Keeping the fixed and variable costs the same, the net profit will double to R$50,000, representing a +100% increase..

Operational leverage, in simple terms, is a measure of how sensitive profit is to changes in sales revenue. It represents a measure of elasticity and remains constant as long as fixed costs do not change, whether they increase or decrease.

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If you want to verify, adjust the sales number to any other value. You will arrive at the same interpretation: for every 1% increase in revenue, Company X will see a 3% increase in its results.

However, it is important to be cautious when using operational leverage, as an increase in sales does not always lead to a proportional increase in profits, especially in volatile business environments where changes in fixed and variable costs can be more significant in explaining results than variations in sales volume.

Generally, an allocation in variable income can benefit from this momentum factor. That is, if we have future predictability about a company's or sector's sales volume, we can identify a shift in profitability for that company and, consequently, position ourselves according to this new direction. To conclude the discussion on a company's total leverage and its overall effects, we will address financial leverage in the next article.

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