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Planning For Profit
The concepts of operating leverage and financial leverage are key to an accurate analysis of a company’s value. A firm is leveraged whenever it incurs either fixed operating costs (operating leverage) or fixed capital costs (financial leverage). More specifically, a firm’s degree of operating leverage is the extent to which its operations involve fixed operating expenses such as fixed manufacturing costs, fixed selling costs, and fixed administrative costs.
A firm’s degree of financial leverage is the extent to which that firm finances its assets by borrowing. More specifically, financial leverage is the extent to which a firm’s Return on Assets exceeds the cost of financing those assets by means of debt. The firm expects that the leverage acquired by borrowing will bring it earnings that will exceed the fixed costs of the assets and of the sources of funds. The firm expects that these added earnings will increase the amount of returns to shareholders.
In the business environment of the new millennium, it is almost impossible for a firm to succeed financially without using some form of leverage. Firms commonly use leverage as a tool to help bolster their financial position and operating condition (for example, their return to stockholders).
However, with increased leverage comes increased risk. If your company chooses to be highly leveraged, it must be willing to accept the risk that the downside losses will be as great as its upside profits. This can easily occur if a firm’s sales volume is not large enough to cover its fixed operating expenses and the required interest payments on its debt.
You can find plenty of examples of this phenomenon in a stack of annual reports from the 1980s. Within that stack you can find several companies that were highly leveraged. Tracking these firms through the 1990s, you would see trends depicting peaks and troughs: the positive and the negative impacts of using leverage to operate a business. Many firms were acquired via "Leveraged buyouts," where the funds needed to make the acquisition were themselves borrowed (hence the term "leveraged").
The likelihood of experiencing these kinds of swings is one reason that managers, analysts, and stockholders must apply the concepts of operating and financial leverage to accurately analyze a firm’s overall value and financial health.
An additional concept that is useful in interpreting the risks due to operating leverage and financial leverage is business risk. Business risk is the inherent uncertainty of doing business. It represents the risk that a company assumes by the nature of the products it manufactures and sells, its position in the marketplace, its pricing structure—in short, all the fundamental aspects involved in the creation of profitable revenues. Assuming a higher degree of operating or financial leverage is seldom risky when the business risk is very low. But if the business risk itself is high, then increasing the degree of either type of leverage compounds the risk.
Analyzing Operating Leverage
Operating leverage is the extent to which a firm’s operations involve fixed operating expenses. Managers can define the degree of operating leverage they want the firm to incur, based on the choices they make regarding fixed expenses. They can, for example, acquire new equipment that increases automation and reduces variable labor expenses. Alternatively, they can choose to maintain their variable labor expenses. Other things being equal, the more automated equipment a firm acquires through capital investment, the higher its operating leverage will be.
Case Study: Greeting Cards
You own a small company that prints customized greeting cards. At present, your variable operating costs are $0.03 per card to print a box of 500 cards, which you sell for $35.00.
One of your employees suggests that, if you purchase a personal computer and a modem, your customers could send their own designs for greeting cards to you electronically. This would save you the cost of doing the design and layout of the cards for each order.
You review some recent orders and find that you paid an employee an average of $3.00 per order to do the design and layout. So your costs and profit per order are as follows:
• Variable $0.03 per card for 500 cards = $15.00
• Fixed design and layout per box = $3.00
• Total cost per box: $18.00
• Operating income per box: $17.00
If you can remove the cost of design and layout, your total costs will drop from $18.00 to $15.00 per order and your operating income per box will increase from $17.00 to $20.00.
On the other hand, purchasing a computer and a modem will cost $1,400. This will introduce a new, fixed cost to the production of the cards. You will have to sell 70 boxes of greeting cards (70 boxes * $20.00 profit) to cover the cost of the equipment—that is, to break even on the investment.
You should base your decision on how dependable your business card orders are. Suppose that you have a steady stream of around 60 orders per month. In that case, you break even on the investment in a little over a month, and after that you show an additional $3.00 profit for every order. That added profit is the result of leveraging your capital investment.
Now suppose that your business card orders are not so dependable. Most of your business depends on the patronage of one large account. When its business is good, and it is hiring and promoting staff, you receive frequent orders from it for greeting cards. But when its business is not so good, you can go for several months with only a few orders.
If the timing of your investment in the computer coincides with a drop in orders for greeting cards, the computer could sit idle for several months. There will be little profit to cover its cost, the break-even point will be pushed well into the future, and you will have lost the opportunity to invest the $1,400 in some other manner, such as advertising. The leverage is actually working against you.
Of course, there are other considerations you must take into account. You would want to consider how many of your customers have the inclination and equipment to send their own designs to you, whether they would demand a price break if they do so, maintenance on the computer, and so on. Business decisions are seldom clear-cut.
So, operating leverage cuts both ways. A good decision can increase your profitability dramatically, once you have broken even on the fixed cost. Bad timing can cut your profitability dramatically if it takes longer than anticipated to break even on the investment.
Case Study: Comparing the Degree of Operating Leverage
For a more detailed example, consider three different specialty stores whose operations are identical in all respects, except for the decisions they have made regarding their variable and fixed expenses:
• Store A has decided to incur the lowest fixed and highest variable costs of the three stores. It has little in the way of special equipment, and relies heavily on the experience and knowledge of its salespeople. At this store, sales commissions are relatively high.
Store A
Fixed costs:	$20,000.00	Variable costs:	$1.50	Unit price:	$2.00
Units Sold (000)	Sales	Fixed costs	Variable Costs	Total Costs	Profits
20	$40,000	$20,000	$30,000	$50,000	($10,000)
50	$100,000	$20,000	$75,000	$95,000	$5,000
80	$160,000	$20,000	$120,000	$140,000	$20,000
110	$220,000	$20,000	$165,000	$185,000	$35,000
140	$280,000	$20,000	$210,000	$230,000	$50,000
170	$340,000	$20,000	$255,000	$275,000	$65,000
200	$400,000	$20,000	$300,000	$320,000	$80,000
• Store B has decided to incur fixed costs that are higher than that of Store A, but to keep its variable costs lower than Store A. This store has invested a moderate amount of money in paint-mixing equipment that enables a salesperson to match paint samples automatically. It believes that reliance on this equipment allows it to hire salespeople who are less experienced; its sales staff therefore does not earn as much as that at Store A.
Store B
Fixed costs:	$40,000.00	Variable costs:	$1.20	Unit price:	$2.00
Units Sold (000)	Sales	Fixed costs	Variable Costs	Total Costs	Profits
20	$40,000	$40,000	$24,000	$64,000	($24,000)
50	$100,000	$40,000	$60,000	$100,000	$0
80	$160,000	$40,000	$96,000	$136,000	$24,000
110	$220,000	$40,000	$132,000	$172,000	$48,000
140	$280,000	$40,000	$168,000	$208,000	$72,000
170	$340,000	$40,000	$204,000	$244,000	$96,000
200	$400,000	$40,000	$240,000	$280,000	$120,000
• Store C has decided to incur the highest fixed and lowest variable costs of the three. It has invested heavily in equipment that not only matches paint samples exactly, but mixes paints automatically to produce a gallon of matching paint. Its salespeople need no special knowledge, and receive lower commissions than the sales staffs at Store A and Store B.
Store C
Fixed costs:	$60,000.00	Variable costs:	$1.00	Unit price:	$2.00
Units Sold (000)	Sales	Fixed costs	Variable Costs	Total Costs	Profits
20	$40,000	$60,000	$20,000	$80,000	($40,000)
50	$100,000	$60,000	$50,000	$110,000	($10,000)
80	$160,000	$60,000	$80,000	$140,000	$20,000
110	$220,000	$60,000	$110,000	$170,000	$50,000
140	$280,000	$60,000	$140,000	$200,000	$80,000
170	$340,000	$60,000	$170,000	$230,000	$110,000
200	$400,000	$60,000	$200,000	$260,000	$140,000
The examples above display an analysis of each store’s sales and Earnings Before Interest and Taxes (EBIT) for a given quantity of sales at their existing fixed costs, variable costs, and unit sales rates.
The examples also make some trends evident. These trends are consequences of each store’s decision as to the relationship between its variable costs and its fixed costs:
Store A, which has the lowest fixed cost and the highest per unit cost, will break even faster than Store B and Store C. However, once the break-even point has been met and as the level of production increases, Store A’s EBIT will not be as great as either Store B’s or Store C’s. This is because Store A has the highest per unit sales cost. No matter how many gallons of paint it sells, it incurs the same, relatively high sales commission on each sale.
Store B, which has fixed costs that fall between Store A and Store B, breaks even slower than Store A but faster than Store C. Once it reaches its break-even point, it is more profitable than Store A because its unit sales cost is lower than Store A. However, after breaking even on its paint-matching equipment, Store B is less profitable, in terms of EBIT, than Store C as sales increase: it pays its sales staff a higher commission than does Store C.
Store C, which has the highest fixed costs and the lowest per unit sales cost, breaks even more slowly than the other two stores. But after the break-even point has been reached, Store C’s EBIT rises faster than either Store A or Store B because of its low sales commission rates.
	Store A	Store B	Store C
Fixed costs:	$20,000	$40,000	$60,000
Variable costs:	$1.50	$1.20	$1.00
Sales price:	$2.00	$2.00	$2.00
		Store A
Units Sold (000)	Sales	Fixed costs	Variable Costs	Profits
20	$40,000	$20,000	$30,000	($10,000)
50	$100,000	$20,000	$75,000	$5,000
80	$160,000	$20,000	$120,000	$20,000
110	$220,000	$20,000	$165,000	$35,000
140	$280,000	$20,000	$210,000	$50,000
170	$340,000	$20,000	$255,000	$65,000
200	$400,000	$20,000	$300,000	$80,000
		Store B
20	$40,000	$40,000	$24,000	($24,000)
50	$100,000	$40,000	$60,000	$0
80	$160,000	$40,000	$96,000	$24,000
110	$220,000	$40,000	$132,000	$48,000
140	$280,000	$40,000	$168,000	$72,000
170	$340,000	$40,000	$204,000	$96,000
200	$400,000	$40,000	$240,000	$120,000
		Store C
20	$40,000	$60,000	$20,000	($40,000)
50	$100,000	$60,000	$50,000	($10,000)
80	$160,000	$60,000	$80,000	$20,000
110	$220,000	$60,000	$110,000	$50,000
140	$280,000	$60,000	$140,000	$80,000
170	$340,000	$60,000	$170,000	$110,000
200	$400,000	$60,000	$200,000	$140,000
Degree of Operating Leverage (DOL)
Another way to understand how operating leverage impacts your company’s profitability is by calculating the Degree of Operating Leverage (DOL):
DOL = Units*(Price-Variable Cost)/(Units*(Price-Variable Cost)-Fixed Cost)
or, equivalently:
DOL = Contribution Margin/(Contribution Margin — Fixed Cost)
Using the data for the three specialty stores, one can calculate the DOL at the point where unit sales are 120,000:
Store A, for example, has a DOL of 1.5 with unit sales of 120,000:
DOL =120,000*($2.00-$1.50)/(120,000*($2.00-$1.50)=$20,000)
DOL = 1.5
These calculations quantify the data shown in example below. The numbers indicate that the EBIT of the companies that have the greatest operating leverage are also the most sensitive to changes in sales volume.
		Store A	Store B	Store C
	Fixed costs:	$20,000	$40,000	$60,000
	Variable costs:	$1.50	$1.20	$1.00
	Sales price:	$2.00	$2.00	$2.00
	Units Sold (000)	Sales	Fixed costs	Variable costs	EBIT	DOL
Store A	120	$240,000	$20,000	$180,000	$40,000	1.50
Store A	200	$400,000	$20,000	$300,000	$80,000	1.25
Store B	120	$240,000	$40,000	$144,000	$56,000	1.71
Store B	200	$400,000	$40,000	$240,000	$120,000	1.33
Store C	120	$240,000	$60,000	$120,000	$60,000	2.00
Store C	200	$400,000	$60,000