Understanding your company’s “operating leverage” is key to understanding your business model. “Operating leverage” refers to your company’s fixed costs as a percentage of total costs (fixed costs + variable costs). Variable costs are those costs that increase as revenue increases, while fixed costs are those costs that stay flat as revenue increases. Having high operating leverage can be good or bad, depending on how your company is performing.
Airlines generally have high operating leverage: they typically have to pay the same for aircraft leases regardless of how the business is doing. When business is booming this is really good – costs don’t increase even though revenue has gone up, meaning profits increase disproportionately. However, this structure is potentially catastrophic when things go bad – even though revenue declined dramatically, the airline still has to pay the same cost for the airplanes. Thus, as we’re seeing today, profitability is greatly impacted.
Retailers like Walmart or Costco will typically have low operating leverage. Much of their costs are variable, stemming from the large amounts of inventory they sell and the extensive part-time labor they utilize to run their businesses. These expenses increase with sales, meaning that spikes in revenue are tempered by higher costs. However, the opposite is also true. If sales dip, these businesses are able to reduce their inventory purchases and use of part-time laborers, thereby protecting profitability in downturns. Thus, compared to a company with high operating leverage, often the good times aren’t as good but the bad times aren’t as bad.
High operating leverage isn’t inherently a good or bad strategy – it just depends on what your industry calls for and what your risk tolerance is. However, at WSI our focus is on helping those companies looking to reduce operating leverage in the logistics space.
A good 3PL can help you significantly reduce your company’s operating leverage. Putting yourself on the hook for warehouses, trucks, personnel, and associated overhead regardless of how your business is doing can put your company in a bind. Outsourcing logistics to a 3PL helps shift the onus of managing these costs on to the 3PL. The 3PL now has to worry about leasing/buying the warehouse and trucks, managing labor costs, and keeping overhead in line with requirements. As the customer, you just pay for what you need for however long you need it. This allows you to better match revenues to expenses, and thereby reduce the volatility in your business model.
Let us know if we can help you reduce your operating leverage: