Operating Leverage

I’m not a finance guy. Which is pretty scary given that I’m theoretically in the “finance profession.” I didn’t even take a single economics class in college. I faked-it-until-I-maked-it and just tried to learn on the job.

Probably the useful concept for me in the context of tech was the notion of “operating leverage.” It basically measures your marginal profit - is your revenue leading to growth or are you just running standing still? One way of looking at this is your fixed costs relative to your variable costs. A business that has high fixed costs relative to lower variable costs has high operating leverage. They make more profit (and not just money) as they get more customers. The classic examples are hotels, restaurants and airlines. The beauty of a business with high operating leverage is that you get a lot of leverage from your customers or users (sorry for circular statement).

As an aside, I think “leverage” is one of the most misused and misunderstood concepts - I didn’t think about the precise definition until I heard this Larry Page quote (one of my favorites): “Use the leverage in the world so you can be truly lazy.” I think Paul Graham does one of the best jobs in describing it in his 2004 essay, “How to Make Wealth.” .

The risk of such a business is that it’s, uh, highly risky. You put a lot of money up front and you don’t know if people will come. You don’t know if you’ll recoup the high up-front costs before it’s too late. You have a low “juice-to-squeeze” ratio, as I like to say.

It’s now a fact-of-life that software-based entrepreneurs can benefit from lower fixed costs because of Amazon web services and the like. The corollary is that you can have a business with “high operating leverage” because the fixed costs have basically vanished. Your only job then is to reduce or at least harness your variable costs, i.e., get users in some automated or scalable way. One example as applied to the Internet is self-service systems. Investors love the “self-serve” model (“Once you can get your ad system from manual to self-serve…”)

Jeff Bezos understood this idea as applied to tech earlier than most. If you read his shareholder letters over their 10+ year existence, operating leverage is a common theme. He made a massive up-front investment in computing capacity, recommendation systems and structured data capabilities to create operating leverage in Amazon’s business. (There’s still an open debate if he’s truly achieved operating leverage as classically defined, but if stock price is one proxy, then he’s achieving his goals.)

[O]ne of the most important things we’ve done to improve convenience and experience for customers also happens to be a huge driver of variable cost productivity: eliminating mistakes and errors at their root. Every year that’s gone by since Amazon.com’s founding, we’ve done a better and better job of eliminating errors, and this past year was our best ever. Eliminating the root causes of errors saves us money and saves customers time. (2001)

In his 2002 shareholder letter, Bezos lays out how his goal is to create operating leverage through customer experience and customer service. He’s trying to automate a highly human-oriented task. It’s like a playbook for many of the e-commerce companies today more than ten years later:

Traditional stores face a time-tested tradeoff between offering high-touch customer experience on the one hand and the lowest possible prices on the other. How can Amazon.com be trying to do both? The answer is that we transform much of customer experience—such as unmatched selection, extensive product information, personalized recommendations, and other newsoftware features—into largely a fixed expense. With customer experience costs largely fixed (more like a publishing model than a retailing model), our costs as a percentage of sales can shrink rapidly as we grow our business. Moreover, customer experience costs that remain variable—such as the variable portion of fulfillment costs—improve in our model as we reduce defects. Eliminating defects improves costs and leads to better customer experience. We believe our ability to lower prices and simultaneously drive customer experience is a big deal, and this past year offers evidence that the strategy is working.

 
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