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The Concept of Operating Leverage

By Fred Schmedt

Posted May 1, 1998

Most business people who borrow money are familiar with the term financial leverage. Financial leverage, expressed as the ratio of debt to equity (L = D/E), refers to the magnitude that a business is financed by debt versus equity. The more debt the greater the financial leverage.

Operating leverage is a lesser known term or concept. Even if you do not borrow money you do not necessarily avoid the risk of operating leverage. Operating leverage measures a firm's fixed versus variable costs. The greater proportion of fixed costs, the greater the operating leverage. Like financial leverage, operating leverage magnifies results, making gains look better and losses look worse. Both operating and financial leverage increase risks because they make returns less predictable over time.

A cow-calf enterprise on native range might be an example of a high degree of operating leverage. Substantial amounts of capital are tied up in land, breeding and working (horses) livestock, housing and pickups for employees, and fences. These are all fixed costs. Their depreciation, interest or opportunity cost, and upkeep - when averaged over output (pounds of calf sold) -are high. Variable costs, however, such as feed and fertilizer, are low - both in total and on a per unit of production basis.

An intensive stocker enterprise on introduced grass offers an example of a low degree of operating leverage. Capital expenditures associated with land, fences and operating equipment are minimal. There is no capital investment in breeding livestock. Variable costs, however, for fertilizer, feed and stocker cattle are high for this type of operation. In a base case scenario the two operations' cost and return structure might look like Chart 1.

Chart 1

Chart 1

In this hypothetical situation both enterprises are extremely profitable, returning $30,000 or 30% of revenues.

What happens if both operations have an opportunity to expand revenue? Assume additional pasture is available for rent and that both operations can handle the expansion with existing assets. The new 'pasture' will add $25,000 of revenue to either operation.

If the cow-calf operation expands, variable costs will run 35% of revenue and fixed costs remain flat at $35,000. (We must assume the operator saved additional replacement heifers, anticipating an opportunity.) Variable costs for the stocker operation will be 55% of revenue and fixed costs are capped at $15,000.

The cow-calf operation's income expanded more than the stocker operation. The net income margin increased from 30% to 37% of revenue. Of the additional revenue, 65% fell through to the bottom line. The stocker operation also benefited from the expansion, but only 45% of the additional revenue showed up in net income. Because of operating leverage the cow-calf operation, with a large fixed cost base, benefited the most from expanding revenues.

What happens if revenues fall? Just as with financial leverage, the operation with the highest operating leverage is hurt the most.

When revenues contract, the cow-calf operation with high fixed costs, and thus high operating leverage, moves into a loss situation. However, the stocker operation, with its low fixed costs, remains marginally profitable.

Is one situation or cost structure better than the other? Not necessarily, because leverage is neither good nor bad. Operating leverage, just like financial leverage, is a higher risk strategy. Each individual must assess the amount of risk he or she is willing to take while striving to achieve their business and personal objectives. Business growth and survival can be dramatically affected by factors as seemingly simple as cost structure. Knowing your farm or ranches' cost structure and learning to manage accordingly can have profound effects on long term business success. If you desire assistance in analyzing the cost structure of your agricultural operation, contact one of the agricultural economists at the Noble Research Institute.

Thought for the Month: "The value of a thing is the amount of laboring or work that its possession will save the possessor." Henry George, 1897

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