In the previous installment of this article, I explained an important aspect of what happens to companies in No Man’s Land: profitability erodes as the company grows. Operating Leverage is a key indicator you can use to predict when you are entering or exiting No Man’s Land. It is a simple diagnostic tool that highlights whether the fundamentals of your business are eroding or improving.
Operating Leverage
To recap: Operating Leverage is the change in operating income (i.e. earnings before interest, taxes, depreciation and amortization i.e EBITDA) divided by the change in revenue or net sales over a period of time, expressed as a percentage. For a company like the emerging growth manufacturing companies I have run, this calculation should be analyzed each quarter and tracked over a period of sequential quarters to establish a pattern or trend.
Change in EBITDA divided by change in sales
(EBITDA new – EBITDA old / Sales new – Sales old)
I also explained why a growing company might find its Operating Leverage trending downward. The company may have outgrown its ability to run an efficient operation at increasing levels of sales, dropping price to raise volumes. Other possible causes:
-
Incurring inflation in raw materials
-
Failing to control its labor costs
-
Product quality problems
-
Downtime
-
Workers comp claims
-
R&D costs running too high
In short, a company with declining Operating Leverage is no longer running an efficient operation. It has outgrown its capabilities and systems and is out of control.
Manufacturing Company Uses Operating Leverage
Let me provide a real world example. A niche manufacturing company makes portable computers and sells them to value-added re-sellers that add application software and services for targeted end user applications. The company was started by an entrepreneur and initially served a specific market need with a single application.
This company is experiencing consistent growth. Resellers are adding software to serve new applications. But - with no pricing strategy in place, all products are being sold at the same price regardless of the end use application. Different markets require different manufacturing credentials, such as ISO certification. The many new customers and applications that its resellers are developing require increased application engineering support.
The results of this uncontrolled growth indicate that the company has entered No Man’s Land. The return level for poor quality is increasing from less than 1% to 4% of revenue. The company is forced to work 3-8 hour shifts 7 days per week, Saturday and Sunday. Factory accidents are on the rise and workers comp claims are increasing. The management team is burned out and personnel turnover is rising. The company’s systems no longer provide sales, customer service, finance and manufacturing information that management needs.
The following chart shows a summary income statement for this company for each quarter in 2012-2013. In 2012 Operating Leverage is declining and the company is clearly in No Man’s Land. For every incremental dollar of sales shipped, only $0.03 is dropping to the bottom line. In 2013, the situation has turned around. The operation has become efficient and for every incremental dollar shipped $0.37 is dropping to the bottom line.
What caused this dramatic turnaround? In terms of the Four Ms framework that my firm uses to help companies get past No Man’s Land, the answer is:
Market – The entrepreneur is now doing what he/she does best. There has been a dramatic reconnect with the customer base, market and channels of distribution. A pricing strategy is established and the appropriate value is being charged for the products sold. The company has learned that it does not need to drop its prices to increase its volume.
Management – The entrepreneur has parted ways with members of the team that were “in over their head” and hired experienced qualified talent to help operate the business. Sales channels, manufacturing and quality, R & D, financial and operating systems have been aligned. Reporting and accountability measures and metrics are in place.
Model – The management team, armed with new systems and financial controls, can now accurately forecast the financial performance of the company.
Money – The entrepreneur is able to attract growth capital from investors because risk has been reduced by the operating improvements described above. With Operating Leverage increased to 37%, the company may not even need outside capital for growth. It may be able to self-fund its growth because it is generating cash at a very high rate.
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
