Split costs by behaviour once, at entry, and you know how much margin expansion volume will deliver on its own and how hard a miss will hurt.
Operating leverage is the percentage change in EBITDA for a one per cent change in revenue, and the quickest way to calculate it is contribution divided by EBITDA. An illustrative company with 60.0 million of contribution and 18.0 million of EBITDA has a degree of operating leverage of 3.33: a 10 per cent rise in revenue lifts EBITDA by 33.3 per cent. A competitor with the same 18.0 million of EBITDA but a lighter fixed cost base scores 2.08, and over a five-year hold the difference is worth 36.2 million of enterprise value at 9.0x.
Worked in full in The Private Equity Operating Partner by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
For an operating partner, operating leverage is the link between the revenue plan and the EBITDA plan. A model that holds the margin constant while revenue grows quietly assumes that every cost is variable, which is rarely true. Splitting costs into variable and fixed, once, at the start of the hold, tells you how much of the EBITDA growth will arrive on its own and how much has to be earned.
Two companies, each with 150.0 million of revenue and 18.0 million of EBITDA, a 12.0 per cent margin. Variable costs move one for one with revenue (materials, freight, commissions, hourly labour); fixed costs do not move with volume within the range considered (salaried staff, rent, systems). All figures illustrative, in millions.
| Line | Company H | Company L |
|---|---|---|
| Revenue | 150.0 | 150.0 |
| Variable costs | 90.0 | 112.5 |
| Contribution | 60.0 | 37.5 |
| Contribution margin | 40% | 25% |
| Fixed costs | 42.0 | 19.5 |
| EBITDA | 18.0 | 18.0 |
| Fixed share of total costs | 31.8% | 14.8% |
DOL = % change in EBITDA ÷ % change in revenue = contribution ÷ EBITDA
New EBITDA = new revenue × contribution margin − fixed costs
Company H: 60.0 ÷ 18.0 = 3.33. Company L: 37.5 ÷ 18.0 = 2.08. In Excel, with revenue in B2, variable costs in B3 and fixed costs in B4: =(B2-B3)/(B2-B3-B4). To check it on history, regress the change in EBITDA on the change in revenue over eight or more quarters; if the slope disagrees with the cost split, the split is wrong.
The two forms agree. With revenue up 10 per cent to 165.0, Company H's EBITDA is 165.0 × 40% − 42.0 = 24.0, a 33.3 per cent increase, and its margin rises from 12.0 to 14.5 per cent. Company L's EBITDA is 165.0 × 25% − 19.5 = 21.75, up 20.8 per cent. Revenue down 10 per cent cuts H's EBITDA to 12.0 and L's to 14.25. Leverage works in both directions, by the same proportion.
Now grow revenue at 6 per cent a year for five years, to 200.73 million, and let fixed costs inflate at 3 per cent a year. Company H's fixed costs rise to 48.69 and its EBITDA reaches 31.60, a margin of 15.7 per cent and EBITDA growth of 11.9 per cent a year. Company L's EBITDA reaches 27.58, a 13.7 per cent margin and 8.9 per cent a year.
| Measure | Company H | Company L |
|---|---|---|
| Exit revenue | 200.73 | 200.73 |
| Exit fixed costs | 48.69 | 22.61 |
| Exit EBITDA | 31.60 | 27.58 |
| Constant-margin EBITDA | 24.09 | 24.09 |
| Operating leverage effect | 7.52 | 3.49 |
| Value of the effect at 9.0x | 67.6 | 31.4 |
| DOL at exit | 2.54 | 1.82 |
A constant-margin model shows both companies at 24.09 of exit EBITDA. Operating leverage adds 7.52 to H and 3.49 to L, worth 67.6 and 31.4 million at 9.0x: a 36.2 million difference between two businesses that look identical on entry EBITDA, entry margin and growth. That value is not created by any initiative. It is the cost structure doing its job: a standard bridge shows it as margin expansion, but it is better attributed to revenue growth than claimed in the operating partner's column. Note also that DOL falls as EBITDA rises, to 2.54 for H at exit: leverage is strongest when margins are thin.
| Revenue change | Revenue | H EBITDA | H change | L EBITDA | L change |
|---|---|---|---|---|---|
| -20% | 120.0 | 6.00 | -66.7% | 10.50 | -41.7% |
| -10% | 135.0 | 12.00 | -33.3% | 14.25 | -20.8% |
| -5% | 142.5 | 15.00 | -16.7% | 16.13 | -10.4% |
| 0% | 150.0 | 18.00 | 0.0% | 18.00 | 0.0% |
| +5% | 157.5 | 21.00 | 16.7% | 19.88 | 10.4% |
| +10% | 165.0 | 24.00 | 33.3% | 21.75 | 20.8% |
| +20% | 180.0 | 30.00 | 66.7% | 25.50 | 41.7% |
The inverse of DOL is the revenue fall that takes EBITDA to zero: 30.0 per cent for H (break-even revenue 105.0) against 48.0 per cent for L (78.0). The same identity, margin of safety equals one over DOL, is worked for break-even planning in how to calculate break-even revenue. The lender sees the table from the other end, as in how operating leverage amplifies a credit downside.
The mistake is to compute operating leverage on gross margin, or to treat every cost below gross profit as fixed. Sales commissions, distribution, energy and temporary labour usually sit in operating costs and move with volume; salaried production supervision often sits in cost of sales and does not. Classify cost by behaviour, not by where it sits in the profit and loss account. The second mistake is to assume fixed costs stay fixed for five years: capacity runs out, and a step in fixed cost (a new shift, a second site) resets the leverage. Model the step where the plan crosses capacity.
Compute contribution over EBITDA for every portfolio company at entry and keep it on one page with the revenue plan. It tells you how much margin expansion volume will deliver by itself, how hard a miss will hurt, and which part of the exit EBITDA the operating team can honestly claim. The value bridge that separates those contributions is built in the free workbook for this case, and the related price question is worked in how much volume a price increase can lose.
There is no good level in isolation: high leverage multiplies growth and decline alike. An illustrative company with a DOL of 3.33 gains 33.3 per cent of EBITDA on 10 per cent more revenue but loses EBITDA entirely on a 30.0 per cent revenue fall; one with a DOL of 2.08 grows more slowly but can lose 48.0 per cent of revenue before EBITDA reaches zero.
Because DOL equals contribution over EBITDA, and EBITDA grows faster than contribution whenever fixed costs grow more slowly than revenue. In the illustrative case the high fixed cost company starts at 3.33 and ends a five-year hold at 2.54, as EBITDA rises from 18.0 to 31.60 million. Leverage is strongest when margins are thin and weakens as they widen.
Not on its own. Margin expansion that comes purely from revenue growth over a fixed cost base would have happened without any initiative, so in a value creation bridge it is better attributed to revenue growth. In the illustrative case it adds 7.52 million of exit EBITDA; claiming it as operational improvement overstates the team's contribution by 67.6 million at 9.0x.
This article is one calculation from The Private Equity Operating Partner. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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