Turning 1 into 2
“Give me a place to stand, and a lever long enough, and I will move the world” — Archimedes
Leverage can be beautiful (just ask your banker), but what is it?
Getting “leverage” means creating a multiplier effect in your business. It’s exponential, not linear. It literally turns 1+1 into 3 (and occasionally 1+1 into 0).
There are several forms of leverage:
- Capital — debt from the bank or equity from investors
- Labor — hiring others to work for you
- Operating — using fixed expenses
Let’s focus on operating leverage today. Starting high level:
- What is operating leverage — the more fixed costs in your business (rent, salaries, etc.), the more your profit will grow with sales growth
- Why it matters — it amplifies both success (growth) and pain (decline) from changes in sales
- How to use it — tightly manage your fixed costs while growing revenue and watch profits explode higher
Wait a minute, you’re telling me I should take on more fixed expenses to make more money?
Not quite.
High fixed cost businesses naturally have more of them (manufacturer, distributor, warehouse, or product-based company) while service-based businesses typically have less.
High fixed costs = more profit growth with sales growth
But the concept of managing your fixed costs applies to any type of business. Hold those expenses as flat as possible and good things will come. Here’s what it looks like in action (blue line is fixed cost and orange line is profit):
In this example, sales grew from $2,000 to $10,000 (a 5x increase), but profit grew from $300 to $4,300 (a 14x increase). That’s operating leverage and it’s powerful stuff!
Remember, this cuts both ways, so profits will fall at a faster rate as sales fall (a key reason we need to continually push for more sales in our business).
How can you put this to work?
In many cases you can decide whether an expense is fixed or variable. Examples:
- Investing in equipment – Replacing hourly (direct) labor with machines or software that require upfront capital but lower costs per unit.
- Lease vs. buy – Leasing usually creates a fixed monthly payment (rent, lease, loan).
- Contractors vs. full-time staff – More payroll/salaries = higher fixed costs. Hourly staff and/or contractors can typically be managed with revenue.
These are just a few example of fixed or variable cost decisions. In addition, you’ll want to calculate the fixed costs in your business and track them every single month (“what gets measured gets managed”).