The following article is adapted from Motley Fool Million Dollar Portfolio.

When I make my semiannual pilgrimage to our local Costco Wholesale (Nasdaq: COST), I'm like a kid in a candy store. A recent trip was no different; I filled my cart with a huge box of Rice Krispies treats and enough Advil to last me through the next bear market. Though I dread the crowds and the lines, without fail, I'm pleasantly surprised by how smoothly the dedicated staff gets me on my way. That efficiency is one of the many reasons I believe that Costco is one of the best-run companies in the United States. There is a lot we can learn from looking at how the companies we own are run -- so read on for my take on a metric that different businesses benefit from in very different ways.

How operating leverage moves a business
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. We care about operating leverage here at MDP because it makes a big difference in a company's earnings power and potential free cash flow growth, especially as the world's economic health changes. 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 companies have low operating leverage, while tech companies, utilities, and airlines have high operating leverage. Let's look at two examples MDP members are familiar with to illustrate how operating leverage can affect a business.

High operating leverage: IPG Photonics
If a company has high operating leverage, that means 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. But there are risks. Fixed costs must be paid whether or not business is booming, so when sales struggle, margins and profit deteriorate quickly.

A perfect example of a company with high fixed costs and operating leverage is Charter Portfolio holding IPG Photonics (Nasdaq: IPGP). As fellow MDPer David Meier wrote in his discussion board post [Editor's note: subscription required] on the company's standout second quarter (more on that below), "The dramatic increases were a function of the turnaround in sales and the nature of IPGP's business model. A vertically integrated business can generate incredible returns if it is sized correctly. But if sales are too light, the high fixed costs eat away the margins, which is what happened during the downturn in 2008-2009." Happily for us, 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 my favorite Rice Krispies treat supplier, Costco. 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.

Fool on,
Ron Gross (TMFGreedandFear)