What is operating leverage? Simple explanation with Indian examples
Operating leverage is one of the most important, yet often misunderstood, financial concepts for Indian investors. If you've ever wondered why some companies see a sharp rise in profits when sales go up, the answer lies in operating leverage.
Let's break it down with simple language and Indian business examples.
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What is operating leverage?
Operating leverage measures how sensitive a company's operating profit (EBIT) is to a change in sales.
In simple terms:
High operating leverage = Small increase in sales leads to a big increase in profit
Low operating leverage = Profits grow slowly even if sales rise
It all depends on a company's fixed costs vs variable costs.
Fixed costs vs variable costs – the basics
Fixed costs: Expenses that stay constant, no matter how much the company produces or sells.
Example: Factory rent for Tata Motors or advertising budget for Hindustan Unilever.
Variable costs: Costs that increase as production increases.
Example: Raw materials for Marico or packaging costs for Dabur.
A company with high fixed costs and low variable costs has high operating leverage.
Simple example of operating leverage (using Indian context)
Let's say a company like Page Industries (Jockey India) spends heavily on advertising, salaries, and manufacturing infrastructure. These are fixed costs.
If sales increase by 20%, profits could jump 50% or more.
Why? Because the fixed costs stay the same, and the extra sales mostly go towards profits.
On the flip side, if sales fall, profits can drop sharply.
Why Indian investors should care about operating leverage
Operating leverage helps you predict how profits will move with sales changes.
In good times: High operating leverage companies can deliver multi-quarter profit growth.
In bad times: These same companies suffer more because their fixed costs remain high.
Example:
During a consumption slowdown, companies like Titan or Avenue Supermarts (DMart) may face profit pressure if their fixed expenses are not covered by lower sales.
How to check a company's operating leverage (quick method)
Look at EBIT growth vs Revenue growth over past quarters.
If EBIT grows faster than revenue, the company has high operating leverage.
Focus on sectors with naturally high operating leverage:
Examples include automobiles, FMCG, retail, and capital goods.
Final takeaway
Understanding operating leverage helps Indian retail investors spot companies that can deliver outsized profit growth during a demand upswing. But remember, it also comes with higher risk during slowdowns.
Before investing, always check both revenue trends and fixed cost structures.
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