Tuesday, March 23, 2010

Operating Leverage

Anita McGahan once explained to us the nuances in a decomposition of the DuPont formula. Where:


In non-math terms: The profitability of a company is a function of it's operating strategy (ROA) and it's financial strategy (FLA).

We've been looking more at this topic (focusing on Operating Strategy) in Operations Management and were introduced to a very interesting idea: Operating Leverage.

Operating Leverage, put simply, is loading up fixed costs to reduce variable costs. Another way of looking at it is similar to capitalized leases versus operating leases. Like financial leverage, increasing operating leverage also increases risk, but increases potential reward.

While debt provides the lever in the financial leverage analogy (and interest expense provides the potential downside), in operating leverage the lever is fixed cost (and sunk cost is the potential downside).

If the volume of quantity demanded isn't equal to the break even amount, there is a significant loss. If the volume of quantity demanded is higher, there is a relatively amplified effect on the profit base through the cost side of the equation.

Excluding the effect of taxes, a basic formula for profit is:

Profit = Revenue - Costs
Profit = (P x Q) - (FC + VC x Q)
= Q (P - VC) - FC

Break even (BE) is when Profit = 0 so

FC = Q (P - VC), where P - VC is contribution margin, CM (profit per unit sold)

Therefore the break even quantity, Q, is defined as:
Q = FC / CM

Using financial leverage as an analogy, I would suggest that it is only truly increasing "operating margin" if the BEQ increases (risk increases). This would only happen if the percentage change in FC is greater than the percentage change in CM (very similar to elasticity).

I believe this would be analogous to a type of operating accretion? In finance, deals are accretive if the cost of capital of the source is cheaper than the cost of capital of the use (buying high return instruments with low return instruments) and is the foundation of financial leverage.

Also, because CM is defined as P - VC, there is an inherent leverage relationship as well as it relates to cost in the same way a commodities based company has a leveraged exposure to it's underlying commodity price. If CM is anchored on one end (P), a change in VC has an amplified effect.

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