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OPERATING LEVERAGE

A project`s break-even point depends on both its fixed costs, which do not vary with sales, and the profit on each extra sale. Managers often face a trade-off between these variables. For example, we typically think of rental expenses as fixed costs. But supermarket companies sometimes rent stores with contingent rent agreements. This meansthat the amount of rent the company pays is tied to the level of sales from the store. Rent rises and falls along with sales. The store thus replaces a fixed cost with a variable cost that rises along with sales. Because a greater proportion of the company`s expenses will fall when its sales fall, its break-even point is reduced.

Of course, a high proportion of fixed costs is not all bad. The firm whose costs are largely fixed fares poorly when demand is low, but it may make a killing during a boom. Let us illustrate.

Finefodder has a policy of hiring long-term employees who will not be laid off except in the most dire circumstances. For all intents and purposes, these salaries are fixed costs. Its rival, Stop and Scoff, has a much smaller permanent labor force and uses expensive temporary help whenever demand for its product requires extra staff. A greater proportion of its labor expenses are therefore variable costs.

Suppose that if Finefodder adopted its rival`s policy, fixed costs in its new superstore would fall from $2 million to $1.56 million but variable costs would rise from 81.25 to 84 percent of sales. Table 5.6 shows that with the normal level of sales, the two policies fare equally. In a slump a store that relies on temporary labor does better since its costs fall along with revenue. In a boom the reverse is true and the store with the higher proportion of fixed costs has the advantage.

If Finefodder follows its normal policy of hiring long-term employees, each extra dollar of sales results in a change of $1.00 Ј $.8125 = $.1875 in pretax profits. If it uses temporary labor, an extra dollar of sales leads to a change of only $1.00 Ј $.84 = $.16 in profits. As a result, a store with high fixed costs is said to have high operating leverage. High operating leverage magnifies the effect on profits of a fluctuation in sales. We can measure a business`s operating leverage by asking how much profits change for each 1 percent change in sales. The degree of operating leverage, often abbreviated as DOL, is this measure.

DOL = percentage change in profits percentage change in sales

For example, Table 5.6 shows that as the store moves from normal conditions to boom, sales increase from $16 million to $19 million, a rise of 18.75 percent. For the policy with high fixed costs, profits increase from $550,000 to $1,112,000, a rise of 102.2 percent. Therefore,

DOL = 102.2 = 5.45 18.75

The percentage change in sales is magnified more than fivefold in terms of the percentage impact on profits.

Now look at the operating leverage of the store if it uses the policy with low fixed costs but high variable costs. As the store moves from normal times to boom, profits increase from $550,000 to $1,030,000, a rise of 87.3 percent. Therefore, DOL = 87.3 = 4.65 18.75

Because some costs remain fixed, a change in sales continues to have a magnified effect on profits but the degree of operating leverage is lower. In fact, one can show that degree of operating leverage depends on fixed charges (including depreciation) in the following manner:4

DOL = 1 + fixed costs profits

This relationship makes it clear that operating leverage increases with fixed costs.

Operating Leverage

Suppose the firm adopts the high-fixed-cost policy. Then fixed costs including depreciation will be 2.00 + .45 = $2.45 million. Since the store produces profits of $.55 million at a normal level of sales, DOL should be

DOL = 1 + fixed costs = 1 + 2.00 + .45 = 5.45 profits .55

This value matches the one we obtained by comparing the actual percentage changes in sales and profits.

You can see from this example that the risk of a project is affected by the degree of operating leverage. If a large proportion of costs is fixed, a shortfall in sales has a magnified effect on profits.

3 The true break-even point for the TriStar program is estimated in U. E. Reinhardt, ¬Break-Even Analysis for Lockheed`s TriStar: An Application of Financial Theory, ­ Journal of Finance 28 (September 1973), pp. 821 Ј838.

OPERATING LEVERAGE Degree to which costs are fixed.

DEGREE OF OPERATING LEVERAGE (DOL) Percentage change in profits given a 1 percent change in sales.