Why Some Companies Grow Profits Faster Than Sales

Hello, I am CS Sandeep Kumar, and today’s topic is Operating Leverage. 

In this video, we will discuss fixed costs versus variable costs, revenue growth and margin expansion, examples from manufacturing and digital businesses, operating leverage during recovery cycles, reverse operating leverage, why businesses with high operating leverage can be volatile, and how to identify reverse operating leverage in company results.  When we analyse companies, a lot of focus is usually placed on revenue growth. But an important question is: is every kind of revenue growth equally valuable?  Two companies may both grow their sales by 15%. However, one company’s profits may grow by 15%, while another company’s profits may grow by 40% or even more. 

Why does this happen? In many cases, the answer is operating leverage. 

What Is Operating Leverage? 

Operating leverage explains the relationship between revenue growth and profit growth.  When a business has a high proportion of fixed costs, even a relatively small increase in sales can create a much larger increase in profits. This happens because not every cost rises at the same pace as revenue.  Fixed costs remain largely stable in the short term. After a certain point, a larger portion of additional revenue starts converting directly into profits. This is why profits can grow faster than revenue in many businesses.  Operating leverage can also be understood from the perspective of scalability. When a business grows but its costs rise at a slower pace, margins begin to improve and profitability can accelerate.  In simple terms, when revenue grows, costs grow at a slower rate and profits grow faster. That is the real power of operating leverage. 

The next question is: which costs remain stable and which costs change with sales? 

Fixed Costs versus Variable Costs 

Broadly, every business has two types of costs: fixed costs and variable costs.  Fixed costs are expenses that do not change significantly with sales in the short term. These can include factory rent, depreciation, permanent employee salaries, technology infrastructure and corporate overheads.  Variable costs, on the other hand, move with sales or production. Common examples include raw materials, packaging, freight and sales commissions.  Why is this distinction important?  Operating leverage is generally most powerful in businesses where fixed costs form a large proportion of the overall cost structure. Once fixed costs are covered, a larger portion of additional revenue can begin to convert into profits.  This is why two companies may report similar revenue growth but show a significant difference in profit growth. 

Revenue Growth and Margin Expansion 

The most visible impact of operating leverage can be seen in margins and profits.  When revenue grows, variable costs also increase, but fixed costs remain largely stable. As a result, a larger portion of additional revenue begins to convert into profits.  This is why revenue may grow by 15% to 20%, while profits grow at a much faster pace. This process is known as margin expansion.  Another important concept is incremental margin, which refers to how much of the additional revenue is converting into additional profit.  The higher the incremental margins, the stronger the operating leverage.  This is why the market does not reward sales growth alone. It also rewards improving margins, faster earnings growth and better profitability.  The process generally follows a simple chain: revenue grows, margins expand, profit growth accelerates and earnings improve.  This is why relatively modest revenue growth can sometimes create a disproportionately large impact on earnings. 

Operating Leverage in Manufacturing Businesses 

Operating leverage is often clearly visible in manufacturing businesses. Industries such as cement, steel, chemicals and auto components require significant investment in plants, machinery and distribution infrastructure. A large portion of these expenses is fixed.  Once capacity has been created, however, additional production can become considerably more profitable.  This is why capacity utilisation is a critical metric.  Suppose a cement plant is operating at 60% capacity. If utilisation increases to 85%, profits can improve significantly even if fixed costs remain largely unchanged.  This happens because the same assets and the same overhead base are now generating more output.  In cyclical industries, one of the biggest drivers of earnings growth may therefore be not just demand growth but improving capacity utilisation.  This is often the stage where operating leverage shows its strongest impact. 

Operating Leverage in Digital Businesses 

Operating leverage can also be powerful in digital and platform businesses. Examples include software companies, SaaS platforms, online marketplaces, stock exchanges and payment networks.  These businesses can require significant initial investment in product development, technology infrastructure and engineering teams.  However, once the platform has been built, the economics can change considerably. The cost of adding new customers or processing additional transactions may be relatively low, while revenue can continue to scale.  As a result, revenue can grow faster than costs, margins can expand and profits can accelerate.  This scalability is one reason why successful digital businesses can achieve exceptionally high profitability over time. It can be one of the most powerful forms of operating leverage. 

Operating Leverage During Recovery Cycles 

Operating leverage can have its strongest impact during recovery cycles. 

During a slowdown, demand weakens and capacity utilisation falls, while fixed costs remain largely unchanged. This can put significant pressure on profits. 

But when a recovery begins, sales and capacity utilisation start improving while the fixed-cost base remains relatively stable. 

As a result, profits can recover much faster than revenue. 

This is why earnings recoveries in cyclical industries can be particularly sharp. 

Because the stock market prices future earnings, cyclical stocks may also begin to outperform during the early stages of a recovery. 

What Is Reverse Operating Leverage? 

Operating leverage does not work only on the upside. It works in both directions. 

Just as rising revenue can accelerate profit growth, falling revenue can create disproportionate pressure on profits. 

This is known as reverse operating leverage. 

When sales decline, fixed costs remain largely unchanged. As a result, margins can come under significant pressure and profits may decline much faster than revenue. 

This is why businesses with high operating leverage can look attractive during strong business cycles but can also face sharp earnings pressure during downturns. 

Why High Operating Leverage Businesses Can Be Volatile 

Many investors view operating leverage only as a positive factor. In reality, it can amplify both returns and risks. 

When demand is strong, margins and profits can grow rapidly. However, when demand weakens, earnings can also decline quickly. 

This is why sectors such as airlines, hotels, multiplexes, metals and cement can experience significant swings in earnings. 

During strong upcycles, these businesses may report extraordinary profit growth, while during downturns they may experience sharp earnings contraction. 

The more powerful the operating leverage, the more important it becomes to understand the associated volatility. 

Conclusion 

In this video, we learnt that operating leverage explains why profits can grow faster than revenue.  We understood the role of fixed costs, variable costs, margin expansion, capacity utilisation and recovery cycles.  We also learnt that operating leverage works in both directions. It can accelerate profits during periods of growth, but it can also magnify earnings pressure when revenue declines.  In the next chapter, we will discuss Working Capital. We will decode this in the next chapter. 

See you in the next video. 

Disclaimer: Investments in securities markets are subject to market risks. Read all the related documents carefully before investing.