FIN500_Mod07_VideoTranscript_P2b Operating Leverage and Breakeven

This part of Lean Finance for Start-ups is a subject that I think gets overlooked an awful lot, primarily because it comes out of cost accounting, manager accounting, and for the most part most students totally check out or don't want to pay attention in this area so I think is very important especially for start-ups, early-stage companies, but any company its key and it's about operating leverage and break-even. Now operating leverage, a real simple definition of it is the degree to which - the degree of fixed cost versus variable cost in a company's cost structure. We're not talking about financial leverage which gets into interest expense and the debt related to equity. This is truly in the cost structure the company; the cost of goods sold, the operating expenses, everything pretty much but EBIT and above. What we want to do here is make sure everybody's aware of the definitions for variable fixed and also what we call mix cost. Variable costs, of course, are those costs that directly vary - go up or down - with sales. Sales volume, sales levels - if there are no costs, if there is no revenue, then there won't be any cost with that particular category. An example, of course, would be cost of goods sold for any product that sold, also sales commissions, advertising that might be based upon a percentage of sales, those costs vary directly with sales levels. Fixed costs, of course, will have little or no correlation with sales volume or sales revenue level, in other words, things like rent, things like salaries over a certain time frame. They're going to be there whether you have revenues or not, so they stay pretty straight, and pretty fixed. And of course there's a bunch of cost categories that are mixed in that they have a little variable a little fixed. An example would be I have a bunch of money, I want to spend it on a Super Bowl ad. Well, it's not really a fixed cost because I expect my revenues to go up a little bit from those sales, but it's very hard in a lot of cases to directly say what level of return I will get on my sales from each dollar spent. So that's a quick variation, a definition of variable fixed and mixed. Now one formula that people use in trying to determine the operating leverage of a company is simply to take the percentage change in profits, and in this case we're going to consider profits EBIT (earnings before interest and taxes or operating profits) the percentage change in profits divided by the percentage change in sales. So in other words, what's the relationship as sales go up or down to bottom line profits? In doing so it's going to tell us what the level of operating leverage there is in the company: what are the degree of fixed and variable costs, we'll discuss in a second why that's important. What can be derived using these fixed variable cost, operating leverage of course, is break-even sales. Of course break-even sales are simply your total fixed costs- let's say over a year's time divided by your contribution margin. Contribution margin, of course, is 1 minus the, your variable costs as a percent of sales or 1 minus variable cost divided by sales. In other words, for each dollar of revenue what's the percentage available after variable costs available to cover my fixed costs? Of course break-even sales dollars, in this definition, it tells us how many sales, what level sales dollars do we have to make in order to cover a fixed cost or have zero profit? Now in relation to operating leverage why this is all important it comes up in the operating structures of start-ups. A lot of times start-ups, entrepreneurs will want to finance their company or start a company with a lot of long-term fixed investments; hire lots of people, buy a lot of machinery, computers, rent or even buy equipment - in other words the load up with the fixed costs and fixed investments at very early stages the company. And in the meantime, they won't have much the in the way of variable cost. On the other hand - and by the way those are considered companies that have a high degree of operating leverage. Now companies that would have a low degree of operating leverage would do a lot of outsourcing, have a lot of costs that are variable in nature, in other words, a lot of commissions, a lot of anything that you'll only have cost in relation to sales; or as we've said, a low degree operating leverage. Why this is critical is that in a start-up a because the predictability of when revenues are going to occur and the level they're going to occur is so difficult to determine, that if we have too high a degree of leverage in the company, it increases what we call the operational risk of the company. In other words, if fixed costs are too high and revenues and the expected contribution margin don't occur at the levels we predict (or the timing of) then the company is really at risk of having too much cost and not enough contribution margin to cover it, and therefore is going to lose a lot of money. And we'll need seek additional financing. and due to the uncertainty of predictability in revenue streams as well as gross profits, or contribution margin is the real key structure to have a developing your initial strategy of your company. I always highly recommend start as a very low degree operating leverage type company with a lot of variable costs and you can easily shift over to more fixed cost as times go on.