In the previous part of this article, I introduced the idea of operating leverage as a simple diagnostic measure of whether your company is entering or exiting No Man’s Land. Operating Leverage is the change in operating income (i.e. earnings before interest, taxes, depreciation and amortization – EBITDA) over a period of time, divided by the change in revenue or net sales over the same period of time. For an emerging growth manufacturing company this calculation should be done and analyzed each quarter and tracked over a period of sequential quarters to establish a pattern or trend.
If a company is tracking its Operating Leverage carefully, it might see, for example, that operating costs are increasing at a lesser rate than revenue. At Operating Leverage of 25%, for every additional dollar that’s shipped over the prior period, $0.25 is dropping to the bottom line on the incremental sales (less any commissions you pay to sales for the increased revenue). On the other hand, if its operating costs are increasing at the same rate as its revenue, its Operating Leverage is approaching 0%. This means that for every additional dollar you ship over the prior period, $0.0 is dropping to the bottom line. And if Operating Leverage is consistently less than 0%, then you are in trouble.
In the case of a middle market manufacturing company, there are many reasons for a company’s Operating Leverage to be trending down or eroding, possible symptoms it has arrived in No Man’s Land. Simply put:
-
You may have outgrown your ability to run an efficient operation at increasing levels of sales.
-
You don’t have a pricing strategy – you’ve dropped price to raise volume but at the cost of sacrificing margin.
-
You are experiencing inflation, i.e. negative PPV (purchase price variance) when buying raw materials.
-
You may be failing to control your labor: incurring too much direct labor or paying too much overtime, in order to make incremental sales.
Other reasons for declining Operating Leverage might include high customer returns due to order entry or quality problems due to manufacturing mistakes. You may be experiencing a higher than normal level of equipment down time because you have outgrown the capability to maintain or operate the equipment. Your worker comp claims may be increasing along with your unemployment rate. Your R & D expenses may be running too high. In short, you are no longer running an efficient operation. You are out of control. You’ve outgrown your capabilities and systems.
A word of caution: when analyzing Operating Leverage trends you may need to normalize unusual events. Operating Leverage analysis assumes that financial reports are based on accrual accounting that matches revenues and costs and capitalizes large purchases. This tends to normalize large variances when comparing period over period results.
In the next and final part of this article, I will present a case study of a company that experienced - and then reversed - a sharp drop in its Operating Leverage.
About the Author
Mike is an experienced CEO who has a record of achieving sustainable sales and earnings growth with domestic, international, public and private companies, both large and small. Learn more or contact Mike directly here.
Connect with Michael on LinkedIn 
Photo Credit: Flickr
