© 2000 John Petroff

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D- Operating leverage

It was seen in previous chapters that there are many styles of management and many types of successful marketing strategies. Each is the result of a continuous adjustment to market, to customers and to competitors. All companies would prefer to charge a high price and achieve a large sales volume. In most cases, competition will, on the contrary, either impose lower prices for large volume, or force a company to seek a niche with a high priced product supported by services for a select clientele in a restricted market, in other words, a small volume. The choice of a large volume (which allows lower cost and therefore prices) usually requires an increase in automation and fixed cost. Variable costs, which consist mostly of direct salaries, are expensive compared with overhead unit cost allocated over a large volume. Thus, the benefit of operating leverage which stems from using large fixed assets to automate and to produce a larger quantity at lower unit cost.

See review questions Q-10D.1 through Q-10D.3.

1)- Increasing profit margins from steady sales:

In Graph G-10.1 below, a break-even type graph is representing two levels of operating leverage. A choice is proposed between operating either with fixed cost FC1, variable cost VF1, and contribution margin P - VC1, or with higher fixed cost FC2, smaller unit variable VC2, and larger contribution margin P - VC2, while total revenue TR remains the same.

Graph T-10.1 shows that a firm can generate more profits by increasing its automation. This can be observed by the size of the profit contribution from each unit of sale, which is represented graphically by the angle formed by the revenue line TR and the total cost lines TC1 and TC2. The angle formed by TR and TC2 is greater than the angle formed by TR and TC1. At any output beyond the break even point, more profit per unit produced is obtained. More profit is naturally desirable. The increase in profits is the consequence of being able to produce cheaper with machines than by using manual labor. The use of machines allows specialization and division of labor. Work becomes more productive. Greater productivity means greater output per man hour and lower labor unit costs. This can be tied to the learning curve mentioned in the previous chapter, or it can be a deliberate strategy of the firm to start out with a large modern plant from the beginning.

Increasing profits may be desirable, but that comes at a price. The price is that the size of potential losses increases along with potential profits. Indeed, a loss is incurred when sales volume does not reach the break-even point. This can be explained in practical terms by the fact that if sales fall off in the case when automation and operating leverage are not used, variable expenses can be cut (e.g. for instance by letting go of excess staff). But if sales of a highly automated firm decline, the equipment cannot be sold without incurring a significant loss: fixed expenses must continue to be incurred. This increase in potential loss is known as operating risk.

Operating leverage can be measured in several different ways. One of the ratios looks at increased profits as a consequence of increased sales, and it is the ratio that is given the name of degree of operating leverage DOL. It is calculated by

DOL = % change in operating profit / % change in sales

or = ((E_t-E_t-1)/E_t-1) / ((S-S_t-1)/S_t-1)

where E = operating profit or earnings before interest and taxes

S = sales revenue

t = time

The practical problem with the ratio is that it depends on the initial level of sale S_t-1 and profit E_t-1 from which the company moved to its target sales S_t and profits E_t. Comparing degrees of operating leverage between companies in the industry with the help of this ratio is not possible because all firms in the industry have different initial sales and profit levels. The ratio is only used in financial planning by management.

For an outside analyst, it is necessary to revert to other measures of operating leverage. Operating leverage can be inferred from
- the relative size of fixed expenses such as overhead and depreciation expenses;
- the relative size of fixed assets such as ones appearing in common size statements;
- the unit cost of goods sold for identical items produced by different firms or in different years;
- the number of labor hours needed to produce one item in different firms or different years.

Notwithstanding the distortions that are known to exist in fixed assets on the balance sheet, the relative size of the fixed assets is the most common method of measuring operating leverage when comparing firms in the same industry. Here, in particular, it would be most inappropriate to compare a firm with firms in other industries because the productive requirements and the optimum size of fixed assets are bound to be different.

The data in Table T-10.2 is used to calculate the degrees of operating leverage of the two alternatives. Alternative 1 with fixed costs of 300, DOL at initial sales volume of 190 striving for 200 is

DOL1 = ((100 - 80) / 80 ) / ((200 - 190) / 190) = 0.25 / 0.0526 = 4.75

For many firms, automation and increased operating leverage is the natural outcome of a wise management strategy that seeks to exploit all opportunities available to it. The product life cycle (extensively covered in Chapter 14) implies that when a product enters its standardization stage, firms must achieve a larger sales volume at a lower price, and therefore a lower unit cost. In the face of increasing competition in a maturing product market, profit margins can only be retained by cost savings from mass production (unless a high price niche is found).

See review questions Q-10D1.1 through Q-10D1.8.

2)- Operating leverage and sales increase:

There is another source of operating risk which comes from the increased break-even point. This is especially true in the case where a firm needs to increase its sales volume to justify automation. After all, the maturing stage of the product life cycle suggests that greater sales volume are achievable. This justifies once again a managerial strategy aiming at increasing sales revenue rather than just profit. It is hoped that profits will increase after the goal of expanded sales has been achieved. But to expand sales within a relatively short period of time, either the existing market share must be increased, or new markets must be entered. Both of these directions necessitate lowering of price and increasing spending on advertising and promotion. The results are a) higher break-even point, and b) erosion of profit margin.

Graph G-10.2 shows the case where the break-even point rises as a result of increases in both fixed costs from TC1 to TC2 and sales targets (form break-even at 145,000,000 units to break-even at 185,000 units), but without lowering selling price (i.e. total revenue Total revenue remains unchanged). As before the profit margin improves from the slope of Profit1 to the slope of Profit2, but not sufficiently to allow a break-even at the same level of sales as without operating leverage.

Graph G-10.2 shows that the break-even point moves up from 145 to 185. The graph also shows that operating leverage will not be an improvement in total profit if sales do not increase beyond 240,000 units (i.e. that is the point where Profit2 exceeds Profit1). The reasoning presented earlier is confirmed that automation imposes on the firm the burden of achieving sales expansion.

Next, in Graph G-10.3, we represent the case where increasing sales cannot be achieved without lowering price shown as a flatter Revenue 2 line than Revenue 1 line. Profit margin improves from Profit1 to Profit2 with the increase in fixed costs as before, but the lowering of the price cuts into the profit margin improvement.

With the improvement in profit margin being reduced by the lower price, the break-even point now moves up to 200,000 units from the initial break-even point at 145,000 units. This requires more than 37% expansion in sales. Moreover, the change in operations will not be beneficial if sales do not expand beyond 290,000 units (i.e. that is the point where PROFIT 2 exceeds PROFIT 1), which is 100% higher than the original break-even point. The decrease in price shown in Graph G-10.3 is only 2%. It is doubtful that in actual markets a lowering of price by 2% (as it is here) could produce the very considerable (100%) sales increase necessary for the operating leverage to improve total profit.

If significantly increasing sales necessitates an increasing market share (as it usually does), because the overall industry does not grow as fast as the company planned sales increase, achieving the sales expansion may not be easy. Indeed, if the market is concentrated, there is a good chance for retaliation by other firms in the industry. Thus, an assessment of operating risk must include an investigation into market concentration and history of retaliation in the industry (discussed in Chapter 14). This difficulty can be especially serious in the latter phases of the product life cycle (see standardization phase in Chapter 14),

In addition to the increase in break-even point, there is also an additional risk coming from the fact that the newly conquered customers may not want to stay with the company. This increased uncertainty (known as commercial risk) is detrimental to the firm. Moreover, the potential for loss increases a great deal more in this case than with the steady market alternative with which the discussion of operating leverage was started. Should the sales fall below the break-even point, the size of the loss will force the firm to close much faster that if the firm had not automated.

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See review questions Q-10D2.1 through Q-10D2.4 .

3)- Operating leverage and sales vulnerability:

The foregoing has shown that the analyst must study operating leverage and profit margins, in the context of the sales strategy of the firm, as well as sales strategies of the other firms in the industry.

Using operating leverage is unwarranted if sales are vulnerable. Sales vulnerability may come from
- excessive cost of conquering an expanded market share in existing markets,
- excessive cost of entering new markets,
- strong likelihood that retaliation will jeopardize sale growth strategy,
- changing tastes of consumers,
- potential government restrictions (e.g. antitrust action, dumping charges, collusion and price fixing).

In all these cases, producing with large variable expenses is wiser than seeking lower unit cost with larger fixed expenses that may put the company in difficulty. Yet, taking risk is part of doing business, and it would also be inappropriate for a firm to follow a conservative strategy, and fail to exploit additional sales that need only a larger production volume to be achieved. This shows the importance of careful analysis based on thorough investigation of consumers and competitors outlined in chapters 14 and 15.

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See review questions Q-10D3.1 through Q-10D3.4.

See research assignment R-10D.1.

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Last modified: Jun/01/01

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