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Chapter 2 of 5 · 10 min

Operating leverage and the margin bridge

With fixed costs, EBITDA moves faster than revenue, in both directions. How much faster is the degree of operating leverage.

By the end of this chapter you can
  • Calculate contribution, EBITDA, margin and the degree of operating leverage
  • Grow revenue and find next year's EBITDA and margin
  • Separate the effect of operating leverage from plain growth
  • Find the revenue a target margin needs
1

The intuition

A cinema pays the same rent and staff whether it sells 100 tickets or 300. Once those costs are covered, almost every extra ticket is profit. Sell 10% more tickets and profit might jump 30%. Sell 10% fewer and profit falls just as sharply, because the rent does not shrink.

That is operating leverage. Costs that do not move with volume (fixed costs) make EBITDA swing further than revenue. Costs that do (variable costs) move in step and cushion nothing.

The key idea

Contribution = revenue × (1 − variable cost ratio). EBITDA = contribution − fixed costs. Degree of operating leverage (DOL) = contribution ÷ EBITDA = % change in EBITDA ÷ % change in revenue.

2

Why it works

  • The conventions here: variable costs are a fixed share of revenue and fixed costs do not move; growth is more units at the same price. DOL is measured on today's numbers.
  • Every extra dollar of revenue brings its contribution margin, and none of it is needed for fixed costs, so all of it reaches EBITDA.
  • DOL is the same in both directions. A business at 3x turns 10% growth into 30% EBITDA growth, and a 10% decline into a 30% fall.
  • The margin rises with revenue because fixed costs are spread over more sales, and falls when revenue falls.
  • The same margin can hide very different risk. Two businesses on 20% margins, one with more fixed costs: that one has higher DOL.
  • Why sponsors care: operating leverage on top of financial leverage is how a bad year becomes a covenant breach, and how a good year becomes a great return.
Revenue $100M; variable costs 60% of revenue; fixed costs $25M
Contribution: 100 × 40%40
EBITDA: 40 − 2515, a 15% margin
DOL: 40 ÷ 152.67
Revenue +10%: 44 − 2519, up 26.7%
Revenue −10%: 36 − 2511, down 26.7%
Revenue for a 20% margin: 25 ÷ (1 − 60% − 20%)125, 25% growth

If every cost scaled with revenue, +10% would give 16.5; operating leverage adds 2.5.

3

The formulas

Contribution = revenue × (1 − variable cost ratio)

What each sale leaves after its own costs.

EBITDA = contribution − fixed costs

The fixed base comes off once.

DOL = contribution ÷ EBITDA

How many times faster EBITDA moves than revenue.

Next year's EBITDA = revenue × (1 + g) × (1 − variable ratio) − fixed costs

Only contribution grows.

Revenue for a target margin = fixed costs ÷ (1 − variable ratio − target margin)

Solve the margin for revenue.

4

Worked example

Contribution, then EBITDA, both years. Only contribution moves with revenue.

Drawing the numbers…
5

See it move

Same company and the same cost structure. Change next year's revenue growth and the margin the sponsor is aiming for. New company and numbers gives a different cost structure.

Drawing the numbers…
Try this
  • Raise revenue growth. EBITDA growth rises faster, the margin rises, and the degree of operating leverage does not change.
  • Take revenue growth below zero. EBITDA falls faster than revenue, and the operating leverage bar turns negative.
  • Set growth to zero. The operating leverage bar disappears: with no change in revenue there is nothing to amplify.
  • Raise the target margin. The revenue it needs rises.
6

Run it backwards

Same company, reversed: the plan calls for a higher margin with no change to the cost structure. What revenue does that need?

Drawing the numbers…

Margin = (1 − variable ratio) − fixed costs ÷ revenue. The first part is fixed, so the margin can only rise by spreading the same fixed costs over more revenue. Rearrange for revenue.

If the growth that needs is implausible, the other lever is the fixed cost base itself, which is where cost-out programs come in.

7

Traps

Growing EBITDA at the revenue growth rate.
Only contribution grows. Fixed costs stay put, so EBITDA grows faster.
Calculating DOL as EBITDA ÷ contribution.
It is contribution ÷ EBITDA, always above 1 when there are fixed costs.
Forgetting it works downwards too.
The same DOL turns a revenue fall into a bigger EBITDA fall.
Comparing risk by margin alone.
Two businesses with the same margin can have very different fixed costs and DOL.
Assuming fixed costs are fixed for ever.
They are fixed over a range. Big volume changes need new capacity, and new fixed costs.
8

Say it in the interview

The interviewer asks

“What is operating leverage, and why does a PE investor care?”

Say yours out loud first, then compare.
9

Check yourself

4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.

Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.

0 of 4
Drawing your questions…
Remember
  • EBITDA = revenue × (1 − variable ratio) − fixed costs.
  • DOL = contribution ÷ EBITDA, in both directions.
  • Revenue for a margin = fixed ÷ (1 − variable − target).
  • Same margin, more fixed costs, more risk.