On Leverage

August 21, 2018

Out with a friend and LoCo Think Tank member the other day, I was introduced to a business owner with whom he was acquainted - an inventor, custom builder, manufacturer, rental business, and online retailer.  Sharp guy, very interesting as you might imagine, with a clearly successful business. As we chatted a bit more, I learned that his multi-faceted business operation is a one-man band - no employees at all! Tried it, didn’t work out, so I just do a little bit of everything he says...

Gasp!  With an economics education and a banking background, this seemed to me a tragedy!  No employees means no leverage, and no leverage in business ultimately means modest impact and earnings and low growth...but I get ahead of myself.  

What is leverage, anyway?  And why and how is it important in business?  We all know the basics of a lever - you’ve got a fulcrum, and an object to be moved, and a handle for the operator.  Ancient philosopher/mathematician Archimedes has a famous quote on topic - “Give me a lever long enough, and a fulcrum on which to place it, and I shall move the world!”  Your claw hammer is a lever for pulling nails, with the top of the head for a fulcrum. When encountering extremely stuck wheel nuts, we used extreme leverage back home on the farm at times, by putting a 5-foot pipe over the end of the ratchet handle - even a skinny guy can turn a rusted nut from the end of a long lever!  

So what then, am I talking about when I mention leverage in a business setting?  In its simplest fashion, and earliest for many businesses, I’m talking about adding people.  For example, if I’m a service company, let’s say a solopreneur handyman service, and I can sell handyman services for $50/hour, then theoretically in a 40-hour week I could earn $2,000 in revenues.  Now, I’ve got to sell these handyman services, so I’m at networking meetings, and doing my social media marketing, and there is also invoicing and administrative tasks, so we’ll say I’m working 60 hours a week to get in my 40 hours billable - or 70 hours to bill 30.  Nevertheless, I think we can agree that $2,000 a week is a maximum revenue for this business. What if, however, I’m an exceptional handyman services seller, or I get a few great referral sources established from my prior industry - house painting. Perhaps I can sell 50 or 100, or let’s say 120 hours of work per week!  So I hire 3 people, paying them each $20 an hour. So now I can bill 120 hours at $50 an hour = $6,000 a week. 40 hours each x 3 x $20 an hour = $2,400 wages, so now I’m making $3,600 a week of income...and I’m not doing any handyman work! Just networking and bookkeeping and invoicing and...you get the idea.  

This example works to introduce operating leverage.  A company with high operating leverage has high fixed costs in relationship to variable costs - much like the company above.  What this means is that once sales are above a certain level, profitability will be high, as the variable expense of another unit of sales is relatively low.  Sell an hour of handyman for $50, and buy it from an employee for $20. Easy peezy. Unless I sell only 40 hours per week of handyman work...so now we’ve got 40 hours x $50 = $2,000, but I’ve still got three guys on payroll total of $2,400 of wages...so now I get to lose $400 for the privilege of being in business and doing all that networking and social media and such.  Leverage is great when it’s working, but dangerous when sales lapse.  

A software development company could be considered to have an extremely high operating leverage.  Let’s say we’ve got 10 developers and admin on the payroll, and they’ve developed this software over the course of a year - $60,000 per staffer a year x 10 = minimum $600,000 sunk (fixed costs), and then a monthly burn rate of $50,000 in wages going forward.  If our software is a $1,000 package, we need to sell 50 a month to cover costs and break even. But the variable cost of producing another copy is almost nil. So if we can sell 100 a month now we’re making $50,000 per month in profit, and if we can sell 1,000 a month we make profit of $950,000 per month!  Now that is leverage. But if no one buys it - a competing firm comes to market first with a superior product, then we might lose $1,000,000 before we give up trying to sell this junk! Leverage, curse you!!  

The other kind of leverage considered in business is financial leverage.  In basic form, financial leverage is the ratio of debt to equity in a business.  The business owner’s capital can be considered like the fulcrum - the more owner’s capital is in play, the more willing a bank will be to lend additional capital into the operation to acquire more factors of production.  Here again, I think a simple example might help to explain.

Let’s say Bob has $25,000 and he wants to start a business.  He buys a 3D printer and sets up a website specializing in the sale of fantasy character figurines from a book series his friend has grown famous over.  With his one printer, Bob can print $1,000 a week of figurines and fulfill them via mail order, so in the first year Bob earns $50,000 (2 weeks off for vacation), and not only has paid for his machine’s cost but earned $25,000 above that.  In 4 years, he’s earned $200,000 on his initial investment of $25,000! Pretty good.  

But demand outstripped supply from the start of this story, and another way Bob could have gone is to use his capital as the fulcrum and borrow $75,000 additional dollars from the bank, and purchase four of the 3D printers.  The loan will be repaid with interest over 4 years at $25,000 a year for a total of $100,000. Earnings, however, are much stronger - $1,000 a week per printer x 4 printers = $4,000 a week x 50 weeks = $200,000 a year! Four years later Bob has earned $800,000 on his $25,000 investment!  

Yay, leverage!!  

Yes, but...what really happened is that the 3D figurines were a passing fad and a year after starting Bob can’t sell the things anymore.  To make matters worse, the printers have been made obsolete by newer technology, and Bob still owes the bank $57,000 and has four nearly worthless printers on his hands.  

Boo, leverage…

Leverage isn’t good or bad in itself.  Much like money, it just is what it does and it’s important that it be understood as it applies to a business setting.  Leverage can and will make a tremendous difference in how a business performs operationally and financially. Used prudently, it can enable growth in revenue and productivity that simply can’t be accomplished without it.  Used recklessly, it can be the ruination of a small business, or a nation...but we don’t have time to get into that!

- Curt Bear

LoCo Founder 

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