Tesla: understanding operational leverage

Today, we're going to talk about Tesla and understanding operational leverage. I'm Professor Michael McDonald. I'm a Professor of Finance at Fairfield University in Fairfield, Connecticut, in the United States and I'd like to help you understand one of the more enigmatic companies and how they've gained so much success over the last few years. So, that's what we're going to be talking about today with Tesla. Let's get started. Now, when

we talk about leverage in finance, we're often referring to financial leverage and financial leverage simply refers to the use of debt in order to lever up returns to equity, but of course, as you might expect, leveraging up your use of debt also levers up your risk. Now, leverage can come in many forms broadly it's any aspect of a business or a small change can have a big impact, like the name "lever" implies.

What we are interested in Tesla's case is not financial leverage, but instead, operational leverage. Operating leverage measures how effectively a firm can increase their operating income by increasing revenue and operating leverage (OL) is a function of the firm's cost structure and the mix of fixed vs. variable costs.

Operating leverage is used to calculate a company's break-even point and help set appropriate selling prices to cover all of their costs and generate a profit. The basic idea is that if a firm has more fixed cost and less variable cost, then as the number of units they sell increases, their operating margin should go up considerably. Companies with high operating leverage have to cover a larger amount of fixed costs every month regardless of whether they sell any units of product. Essentially, you've got a higher break-even point, but as you add additional incremental sales over and above that break-even point, every incremental dollar contains more profit. Your gross margins are higher. Low-operating-leverage companies may have high costs, vary directly with their sales, but they have lower fixed costs to cover each month. You can think about different industries and different types of firms that would fall into each category. For example, think about something like a software company, do you think they're a high operating leverage firm or a low operating leverage firm? How would that compare to something like, for instance, a trucking company, say moving products or freight down the road in a truck. Would they be a high operating leverage firm or a low operating leverage firm? Well, in the case of the software company, they don't really have any per unit variable costs for the most part. They've got a lot of fixed costs to develop that software upfront, but they don't have much in the way of variable costs, whether they sell 1000 software licenses or 1 million, largely their fixed costs are going to be the same and their variable costs are going to be pretty minimal for each additional unit. In contrast, for a trucking company, well, every time we send that truck out on the road, we have incremental additional cost, There's the cost for a driver to drive that truck, there's the cost for gasoline, for insurance and everything else. The truck itself is a fixed cost, but we're going to have relatively high variable costs that go along with it, and hence, low operating leverage. Now the operating leverage formula is what you see here.