Back in the day when analysts were still getting paid in investment banking, a friend decided to “invest” in a $80,000 Porsche. His reason was to “use this baby to woo and close on a wife asap then hopefully afford car payments on a dual income.” Those who know me well also know how I sometimes believe that everyone is entitled to my opinion. So, I offered my friend a lesson on operating leverage that I will revisit today.
Operating leverage is the degree to which a business has fixed costs. Let’s consider two companies with $500 of fixed production overhead. Assuming that pricing and contribution margin are held constant, the business with lower revenue will have higher operating leverage. The table below illustrates the concept. As units sold increase, fixed and total cost per unit drop, but dollar savings progressively become smaller.
There is a catch. Companies still need to work diligently in order to unlock operating leverage, e.g., through:
- Revenue growth – My friend’s ultimate goal/revenue was to find a wife so I urged him to go, with his car, to as many dates as possible to maximize the number of potential candidates/units reached/sold (not as comparable really). We also discussed possibly renting out the car during downtime or Ubering on the way to dates. Companies with high fixed costs have to quickly cover them by growing revenue e.g., through finding new customers, applications and/or related revenue streams.
- Margin expansion – We also considered using non-premium gas for the car and having some dates at cheap restaurants. Companies can increase price and/or decrease cost. However, as we have learned, increasing contribution margin ain’t easy.
- Capacity utilization – I also suggested that my friend drive his car to as many dates as possible even for candidates that didn’t satisfy his marriage profile, but potentially provided other value e.g., great conversation. Companies call this private label. Unfortunately, private label is often low-margin and might require additional investment in order to meet different customers’ specifications. Furthermore, companies need to unlock additional capacity to accommodate private label orders that are usually lumpy and unplanned.
My friend succeeded in his mission, but in reality, the car turned out to be serious overkill. Most dates decided on an encore based on substance of the discussion and experience. By the time the car was retrieved from six blocks away, they were too tired to notice. If he hadn’t succeeded quickly enough, his car and rent payments would have sunk him and he would have been forever a sad bachelor.
Some entrepreneurs I speak to tout several benefits of in-house manufacturing, which include; independence from contract manufacturers, flexible production and inventory planning, ability to customize and produce different Skus e.g., seasonal products, branding reasons e.g., supply chain control. In my view, when put into perspective, these benefits often aren’t “must-haves” for smaller companies. Fixed costs hog cash, increase pressure to “grow now”, reduce nimbleness and can generate negative retained earnings. I encourage companies to avoid piling up fixed costs before investigating cheaper (maybe not as convenient) alternatives.