calculating operating leverage

I’ve written a number of posts on operating leverage.  You can use the search function on the blog to get them.

The basic idea is that a company has both fixed costs, which it must pay whether it sells anything or not, and variable costs, which are a function of the number of things a company sells.  Once a company covers its fixed costs through sales, the operating profit on additional sales can be very high.  This is a key source of positive–and negative–earnings surprise.

As a practical matter, though, how can we calculate how operating leverage works in a given company?

For some firms, it’s impossible.   Take 3M (MMM).  It makes a gazillion different items, many of them sold in massive quantities. For an investor, there’s no way to see very deeply inside the company.

We also have to realize that the data we get from any company’s financials is going to be imperfect, at the very least during our initial look.  If we take the time and energy to compare our projections to the actuals the company publishes, listen very carefully during management conference calls for clues, and call the company every once in a while, we may be able to refine the numbers we come up with in a surprisingly significant way.

Nevertheless, for smaller companies that sell only one or two main products, there’s a very simple way to get an idea of whether a firm has significant operating leverage or not:

–take two most recent consecutive quarters

–subtract the revenue reported for Q1 from the revenue reported from Q2

–subtract the operating income of Q1 from that of Q2

–calculate an incremental operating margin by dividing the operating income change by the sales change

–compare that with the operating margin achieved during either quarter.

An example:

Harley-Davidson (HOG–I own shares, despite the fact the ticker symbol spells a word) sells motorcycles, spare parts and branded merchandise.

During 2Q13, the company posted motorcycle-related revenues of \$1.631 billion and operating profit of \$362.9 million.  The operating margin was 22.2%.

During 1Q13, HOG had motorcycle revenues of \$1.414 billion and operating profit of \$279.0 million.  The operating margin was 19.8%.

The quarter-on-quarter revenue difference was \$217.9 million, and the q-on-q operating profit difference was \$83.1 million.  The operating margin on the extra production was 38.1%.

In HOG’s case, we can go on to make a number of refinements.  We can try to separate out the profits from sales of merchandise and spare parts, which are relatively small in revenue in comparison with motorcycles but which carry higher margins.  And we can examine whether the much higher margin on incremental sales comes from manufacturing efficiency or from leveraging SG&A (it’s the latter).

But the main point is clear.  HOG makes almost twice as much on incremental sales as it does on average sales.  And we found this out just by making some simple subtractions.