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Credit Analysis: Fixed Costs and Operating leverage

Fixed Costs and Operating Leverage

Are fixed costs evil? And if they are evil then why do businesses willingly take them on? Should management depend entirely on variable costs to run its business? Is there any way that we can answer these questions? There is no right answer to the first three questions but we can take a shot at answering number four (YES) and see if Operating leverage can help us understand why decision makers opt for a balance between fixed and variable costs.

When fixed costs are incurred a big question is effective utilization of the service, resource or asset being financed. Remember, whenever fixed costs are incurred they have an impact on production levels and sales. When they rise, the Breakeven Point rises with them and vice versa. I run a business. My sales forecasts project that the sales organization can sell another 10,000 units a month. The cost of adding that capacity is 12,000 dollars a month in lease payments for additional equipment. What if I spent the 12,000 dollars and the sales force didn’t deliver. Three things happen, the increased production capacity is not utilized, the 12,000 a month goes to waste and I now need another 12,000 in revenues to cover the additional fixed costs. Since it’s a fixed commitment, there is not much that can be done on the cost side.

Whenever fixed costs are incurred they have an impact on production levels and should have a corresponding impact on sales. Managers need to translate this impact to numbers that they can use before the fixed cost structure is changed. Is the new break even attainable? Will profitability be higher? Would the variable cost structure improve with the additional volume? Does all of this in any way imply that a firm should minimize its fixed costs?

Operating leverage measures the ability of a firm to lever the fixed cost structure and magnify the effect of change in sales on its earnings. It is a relationship between the firm’s sales revenue and its operating income. The higher the ratio of fixed costs to operating income, the higher the operating leverage and the higher the magnification impact on income due to a change in sales.

Why is it important? Fixed costs are an integral part of any business operation. Incremental (additional) fixed costs are incurred in the hope that the additional volume produced will generate sufficient revenues to cover these costs. Operating leverage helps us measure and understand the utilization of fixed costs by studying the relationship between operating profits, and sales volume. Are we putting the costs to rigorous use or is money being wasted? The concept helps us measure the degree to which a firm uses fixed production costs in its operations.

The numerical measure of this concept is known as the Degree of Operating Leverage. This calculation results in a numerical figure that helps us compare the figures for operating leverage for two or more companies over time.

 Degree of Operating Leverage

The relationship between Operating Income and Sales

Degree of Operating Leverage is a numerical measure that helps an analyst compare the situation of two firms or of one firm over a period of time. The measure shows the relationship between Operating Income (or EBIT) and Sales of a business at a particular production level.

Let’s take a look at the income statement for Blimey & Co for 1999.

Blimey & Co.

Income Statement
Sales$105,000
Less: Cost of Sales$20,000
Gross Profit$85,000
Less: Operating Expenses$15,000
Operating Income$70,000
Less: Other Expenses and Taxes$20,000
Net Income$50,000

 

When a proportionate change in EBIT, due to a change in sales, is more than the proportionate change in sales, operating leverage exists. Degree of Operating Leverage is the magnification factor by which % change in EBIT exceeded the % change in sales. The formula is fairly simple and is computed by:

DOL =    % change in Operating Income / % Change in Sales

Consider a situation where the firm has financed all of its assets through equity. Hence, there are no fixed financial charges (interest payments). We are only dealing with fixed operating costs. Operating Income or EBIT and Sales for the years 1998 and 1999 are:

Income Statement19981999
Sales$85,000$105,000
Cost of Operations$45,000$35,000
Operating Income$40,000$70,000

What is the percentage change in sales between the two years?

% Change in sales
Sales in 1998$85,000
Sales in 1999$105,000
% Change in sales23.5%

 

The percentage change in sales is 23.5%.

What is the percentage change in Operating Income or EBIT?

% Change in Operating Income
Operating Income in 1998$40,000
Operating Income in 1999$170,000
% Change in Operating Income75%

The change in operating income is 75%.

We can see that a 23.5% increase in sales results in a 75% increase in operating income. Using the formula above, Degree Of Operating Leverage is:

DOL =    % Change in Operating Income / % Change in Sales

DOL =     75% / 23.5%

DOL =    3.19

Notice that a 23.5% increase in sales was magnified into a 75% increase in operating income. This magnification is a direct result of the level of fixed costs.

Let’s try another example:

We are analyzing three independent businesses. Shoes, Socks and Ties. The income statements of the three firms are given below:

Income StatementShoesSocksTies
Sales$1,000,000$1,000,000$1,000,000
Variable Costs$200,000$600,000$800,000
Contribution Margin$800,000$400,000$200,000
Fixed Costs$700,000$300,000$100,000
Net Income$100,000$100,000$100,000

In this example, sales and income levels are same for all three firms. However cost structures differ. Out of total costs of $ 900,000, which all three firms have, the fixed and variable portions vary by a wide range<

Income StatementShoesSocksTies
Variable Costs$200,000$600,000$800,000
Fixed Costs$700,000$300,000$100,000
Total Costs$900,000$900,000$900,000

 

Shoes has the highest amount of fixed costs and also the highest amount of contribution margin. Socks is next in line with fixed costs of $300,000, followed by Ties with fixed costs of only $100,000. The contribution margin can also help us gauge the level of operating leverage that a firm has. If fixed costs are high (they contribute a large portion of the cost structure) then contribution margin for such a company will be high because variable costs should be lower. Implying that a high contribution margin denotes a high level of operating leverage. The contribution margin for the three companies is as follows:

Contribution Margin
Shoes0.8
Socks0.4
Ties0.2

Now let’s assume that sales increase by $300,000. What will be the increase in profits if fixed costs and contribution margin remain the same?

Contribution MarginIncrease in SalesIncrease in Income
Shoes0.8$300,000$240,000
Socks0.4$300,000$120,000
Ties0.2$300,000$60,000

 

Shoes, which was most highly leveraged (had the highest contribution margin), experienced the highest increase in profits when sales increased. Note that the increase in sales has been the same for all three firms. A high amount of operational leverage has levered up or magnified the change in income for a given change in sales for all three firms. Shoes, which had the highest leverage to start with has benefited the most from this magnification.

If a high level of operating leverage magnifies or levers up changes in income for a given change in sales, then will this magnification take place even when sales drop? What will the direction of this magnification be? We will leave you with this question for a while, and move on to a discussion of another method that can be used to calculate degree of operating leverage.

The following formula provides an alternative method of calculating degree of operating leverage:

DOL    = [Sales in units * (Selling Price per Unit – Variable Cost per Unit)] [Sales in units * (Selling Price per Unit – Variable Cost per Unit) – Fixed Cost]

Notice that this equation is simply an extension of the one we saw in the last concept, that is

DOL = % Change in Operating Income  / % Change in Sales

The difference is that instead of using percentage changes in Operating Income and Sales, we take absolute figures. Let’s try our hand on some more calculations using the formula above. Bouncing Balls Inc. sold 200,000 units at a selling price of $12 and a variable cost of $8 per unit, with fixed costs of $250,000.

DOL    =  [Sales in units (Selling Price per Unit – Variable Cost per Unit)] [Sales in units (Selling Price per Unit – Variable Cost per Unit) – Fixed Cost]

DOL    = [200,000 (12 – 8)] [200,000 ( 12 – 8 ) – 250,000]

DOL    = 800,000 / 550,000

DOL comes out to be 1.45

Notice that if the $250,000 worth of fixed costs were not present, DOL would be 1, because the numerator and denominator in the above equation would have been the same.

The downside of operating leverage

All is well for a company that experiences increases in sales or good times? But do good times last forever? Is it possible for all firms to experience an increase in sales at all times? Of course not!!

We now return to the question that we asked earlier on:

If a high level of operating leverage magnifies or levers up changes in income for a given change in sales, then will this magnification take place even when sales drop?

The answer to this question is — You bet!! Magnification will be in the same direction as the change in sales. If sales drop then the decline in income will be magnified. Just as operating leverage has a positive magnification effect in good times (when sales increase), it has a negative magnification effect in bad times (when sales go down – during a recession or an economic slow down).

A firm with high operating leverage will be exposed to a higher degree of risk when sales decline. Such a firm will also have a higher breakeven point, as we have seen in earlier sessions, than a firm with low levels of operating leverage. This can cause result in financial distress.

Let’s try an example:

We’re dealing with the same three companies, Shoes, Socks and Ties. Shoes is the one with the highest fixed costs and therefore the highest degree of operating leverage:

Shoes Socks Ties 
Fixed Costs$700,000$300,000$100,000
Contribution Margin0.80.40.2

 

We’ve seen the beneficial effects of operating leverage when sales increases. Let’s see what happens if all three firms experience a decline of $200,000 in sales. It is important to remember that at present, all three businesses have the same level of sales ($1,000,000) and the same level of Income ($100,000). The effect of a $ 200,000 drop in sales is shown below:

Contribution MarginDecrease in SalesDecrease in Income
Shoes0.8$200,000$160,000
Socks0.4$200,000$80,000
Ties0.2$200,000$40,000

With a drop in sales, income drops in all three firms. However, the decline is greater for the firm with the most leverage (Shoes).

In slow downs, recessions or declining revenue scenarios, high degree of operating leverage is bad for business. Ties Inc is the firm with the lowest level of leverage in the example above. Although the decline in sales has been the same for all three firms, Ties is much better off than others in terms of profitability.

Everyone can meet expenses and costs when things are going well (or do well in a bull market). However, they must be able to stay afloat when things turn sour. A high level of operating leverage results in a larger dent in the firm’s income when sales go down. These are the hidden costs associated with leverage – something that managers sometimes ignore with fatal consequences.

Finally, remember, the breakeven for a highly leveraged company is also high. Recall that the breakeven point is calculated as:

BE point = Fixed Costs / Contribution Margin

Where

Contribution Margin = (Sales – Variable Costs)

The Breakeven point for Shoes, Socks and Ties are:

Breakeven PointFixed CostsContribution MarginBreakeven Point
Shoes$700,0000.8$875,000
Socks$300,0000.4$750,000
Ties$100,0000.2$500,000

 

So, businesses with highest operating leverage also have the highest breakeven point and vice versa. This further adds to the risk associated with highly leveraged firms in a downturn.

There is a certain risk inherent in a firm’s operations, which in part results from the acquisition of fixed costs. This is known as business risk and it has serious implications for a firm that indiscriminately takes on leverage (operational or financial). Leverage is not cheap and it is important for businesses to understand all associated costs. The hidden costs, as shown above, can be very taxing, especially during hard times.

The decision of a manager on the level of leverage depends not only on internal factors but also on expectations about the future state of the economy, the industry, demand conditions, competition etc. If you foresee a bleak future, it would be unwise to carry high fixed costs, as inflexibility in the cost structure will affect the firm negatively during a financial crunch.

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