The Hidden Dangers of Operating Leverage: A Deep Dive into Risks

You’d think that by now, businesses would have a firm handle on their operating leverage. After all, the concept is simple enough: increase your fixed costs, lower your variable costs, and enjoy the profits when sales rise. Sounds like a winning formula, right? Yet, time and again, companies fall victim to a silent, creeping danger—a danger that isn’t immediately obvious but is lurking beneath the surface. This risk, if mishandled, can unravel even the best-laid business plans. But what exactly is this risk?

Here’s where it gets interesting. Picture this: sales are booming, and your fixed costs, whether for machinery, real estate, or other long-term investments, are covered. Your profits soar, seemingly with little extra effort. However, what happens when sales slow down? What if the economy falters, demand for your product declines, or a competitor enters the market with a more appealing offer?

This is where operating leverage bites back. The very same fixed costs that magnified your profits during boom times can just as easily magnify your losses when sales shrink. Suddenly, the same cost structure that made your business seem invincible is now an anchor pulling you down. The risk lies in the inflexibility of your cost structure.

Take, for example, a company that has invested heavily in automated production lines. When demand is high, the company’s variable costs are relatively low, and they reap the benefits of high margins. But when sales plummet, those fixed costs, such as machinery upkeep and depreciation, don’t go away. Even worse, the company may be forced to cut prices just to keep its production lines running, eroding profits even further.

Let’s put this into context with some data.

Year	Sales (in millions)	Fixed Costs (in millions)	Profit/Loss (in millions)
2020	100	50	20
2021	150	50	50
2022	80	50	-10

In 2021, the company enjoys a surge in profits, as higher sales far outweigh its fixed costs. But come 2022, a significant drop in sales leads to a loss, as the fixed costs remain unchanged. This is the double-edged sword of operating leverage.

There’s a psychological factor here too. Companies that experience a high degree of success due to operating leverage during boom times may become overconfident. They might expand even further, taking on additional fixed costs—believing that their growth is sustainable. But markets are unpredictable, and when downturns hit, they hit hard.

Another dimension to this risk comes in the form of financing. Companies with high operating leverage are often tempted to take on more debt, assuming that future sales will cover both their fixed costs and their debt repayments. However, in the event of an economic slowdown or industry disruption, this strategy can backfire. Now, not only are fixed costs burdensome, but debt repayments add further strain. It becomes a vicious cycle, where dwindling cash flows are swallowed up by obligations, leaving little room for strategic maneuvering or reinvestment.

So, what can businesses do to mitigate the risks associated with operating leverage?

1. Maintain flexibility in cost structures: Whenever possible, companies should aim to keep a portion of their costs variable, rather than fixed. For instance, instead of purchasing expensive machinery outright, they could lease equipment or outsource certain production functions. This approach allows them to scale operations up or down based on demand, reducing the burden during slower periods.

2. Conduct regular stress tests: Businesses should model various scenarios to understand how changes in sales volume will affect their financial performance. By stress-testing their operations under different conditions, they can anticipate potential pitfalls and adjust their strategies accordingly. This proactive approach enables them to remain agile and avoid being blindsided by downturns.

3. Diversify revenue streams: Companies that rely heavily on a single product line or market are more vulnerable to downturns. Diversifying revenue streams can help buffer against unexpected declines in demand. For example, a manufacturer that also offers maintenance services or consulting can generate income even when product sales are slow.

4. Implement agile pricing strategies: In times of economic uncertainty, businesses need to be nimble with their pricing. Offering discounts to maintain volume, bundling products, or creating loyalty programs can help sustain cash flow. But it's critical that these strategies don’t further erode margins to the point where fixed costs cannot be covered.

5. Keep a close eye on debt: Leveraging debt to fuel expansion can be a double-edged sword, particularly for businesses with high operating leverage. It's essential to maintain a healthy balance between growth ambitions and financial prudence. Companies should avoid overleveraging themselves during good times and ensure they have adequate reserves to weather downturns.

6. Emphasize cash flow management: Cash flow is king, especially for businesses with significant fixed costs. By maintaining strong cash flow discipline, companies can ensure they have the liquidity needed to meet their obligations, even during slower sales periods.

Real-World Example: The Airline Industry

Consider the airline industry, which operates with extremely high fixed costs. Planes, maintenance, airport fees, and staff salaries all represent massive expenditures that don't disappear when fewer passengers fly. In boom times, airlines can be highly profitable. But during downturns, such as the COVID-19 pandemic, those same costs became insurmountable for many carriers. Planes still need to be maintained and leased, even if they’re grounded, leading to billions in losses across the industry.

One of the most striking examples is Virgin Australia, which entered voluntary administration in 2020. The airline had taken on high fixed costs and debt to fuel its expansion, assuming that steady growth in air travel would continue. When the pandemic hit, the drop in passenger numbers left it unable to meet its financial obligations, highlighting how vulnerable businesses with high operating leverage can be in times of crisis.

Operating leverage is a powerful tool that can supercharge profits—but it’s also one that can magnify losses when things go wrong. The key lies in balancing risk and reward, ensuring that businesses remain agile, and not overextending themselves during periods of success.

In the end, the risks associated with operating leverage are best managed by staying flexible, preparing for downturns, and maintaining strong cash flow discipline. Otherwise, companies may find themselves on the losing end of the leverage equation.