Do you know what the cost structure of your favorite company looks like -- or why it matters?
Understanding the relationship between fixed and variable costs is an important part of determining a company's operating leverage -- how changes in sales, relative to a company's cost structure, can power (or deflate) the business.
As the lead advisor of The Motley Fool's Million Dollar Portfolio, I care about operating leverage because it makes a big difference in a company's earnings power and free cash flow growth. Understanding these concepts helps me to effectively manage this real-money portfolio, which allows our members to follow along at home, trade for trade.
But before we dig deeper into this important metric, let's take a step back and define our terms:
- Fixed costs: Often referred to as overhead, these include things like lease payments on factories and executive salaries -- basically, expenses that don't change even as production or sales change.
- Variable costs: These expenses do change as sales activity changes. Think raw materials, packaging, and hourly labor directly involved in making or selling products.
- Operating leverage: This is the relationship between a company's fixed and variable costs. The higher a company's fixed costs compared with its variable costs, the higher its operating leverage.
Retailers and labor-intensive industries such as restaurants and accounting firms have low operating leverage, while technology companies, utilities, and airlines have high operating leverage. Let's see how operating leverage can affect a business.
High operating leverage: IPG Photonics
If a company has high operating leverage, it can squeeze more money out of each additional sale. When a company's cost structure is largely based on fixed costs, it doesn't need to spend additional dollars when a new business prospect comes along or a current customer increases its order. The company already has the necessary assets in place, such as manufacturing facilities, equipment, and those well-paid executives, so it doesn't need to spend tons of money to meet the increased demand.
Those savings help raise the profit margin, and earnings grow at a faster rate than sales. A great example is Microsoft (Nasdaq: MSFT ) , which has a high fixed cost structure that stays relatively constant regardless of sales volume. Once those fixed costs are covered, additional sales drop right to the bottom line.
But there are risks. Fixed costs must be paid whether or not business is booming; when sales struggle, margins and profit deteriorate quickly. Newspaper companies such as The Washington Post (NYSE: WPO ) and The New York Times (NYSE: NYT ) have gotten themselves into a heap of trouble as a result of their fixed cost structures.
A perfect example of a company with high fixed costs and operating leverage is IPG Photonics (Nasdaq: IPGP ) . IPG's second-quarter results revealed the dramatic improvement that resulted from a sales turnaround and the nature of IPGP's business model. A vertically integrated business can generate incredible returns if it's sized correctly.
But if sales are too light, the high fixed costs eat away the margins, which happened to IPG during the downturn in 2008-2009. Happily for investors, IPG is benefiting from increasing sales, and because of its fixed cost structure, this is leading to a significant rise in margins and cash flow.
Low operating leverage: Costco
On the flip side, companies with low operating leverage have variable cost structures, which better positions them to do well when times are tough. Variable costs fall when the economy is struggling, and companies without the burden of high fixed costs can be nimble and adapt more quickly. This can allow a company to turn a profit even when it brings in less revenue.
A great example is one of the finest-run companies in the U.S., Costco (Nasdaq: COST ) . Inventory and part-time labor make up a large part of its cost structure. When times are good, Costco will spend more on inventory, stocking its shelves with a ton of merchandise. It will also bring on more part-time workers. But if things turn south for a bit, Costco can lighten up on inventory and cut most of its workforce's hours, helping the company continue to wring out a profit.
Foolish bottom line
To sum up, there are three things to keep in mind when looking at the operating leverage of a potential investment:
- Companies with fixed cost structures enjoy a rapid rise in margins and profit when there is an increase in sales.
- Companies with variable cost structures can make money with lower sales, but they have less upside to their margins.
- In an economic downturn, variable cost structures help companies cut costs quickly.
But operating leverage is only one component of a great company. If you'd like more stock ideas, enter your email in the box below to get "Motley Fool Top Picks & Perspectives 2011," a new free report with stock recommendations and portfolio guidance for the year ahead. We'll also tell you more about Million Dollar Portfolio, our real-money portfolio service that buys the best of our investing ideas, opening for the last time this year. To get started, just enter your email in the box below.