Working Capital Management: A Business Approach

Part III: Ancillary Topics

CHAPTER 9

OPERATING AND FINANCIAL LEVERAGE

OPERATING LEVERAGE

In the last chapter we explored the production function and its rela-
tionship to economic efficiency (productivity) and profitability. We
learned that the mix of inputs (labor and capital) were important determi-
nants of the firm’s profitability. We also learned that there are three dis-
tinct levels of production activity (output) where (1) costs are minimized,

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(2) sales are maximized, and (3) profits are maximized. The important
implication of the relationships between labor and capital is that it is not
possible to maximize all three simultaneously in a perfectly competitive

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market environment. Accordingly, managerial objectives will drive the

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production-output decision in the long run.
We continue the exploration of economic performance by examining
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the relationship between output levels and profitability. Implicit in the
production function’s labor-capital ratio is the concept of operating lever-
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age. Operating leverage is that characteristic of the firm’s variable and
fixed cost structure that determines the slope of the total cost line and the
break-even point. When firms alter their production functions, they are
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also changing their operating leverage. Changes in operating leverage af-

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fects the slope of the total cost curve and the break-even point. Because of
the relative difficulties in estimating the firm’s labor and capital intensity
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factors as defined in chapter 8’s equation 8.2, a simple method has been
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developed using income statement data to measure the degree of operating

leverage (DOL) used by the firm.
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Degree of Operating Leverage (DOL)

Firms substituting capital for labor are described as increasing their

capital intensity; e.g., they are automating their transformation processes.
From an accounting perspective, firms increasing their capital intensity
will typically incur a higher level of fixed costs. The increase in fixed
costs occurs because capital equipment replaces some of the variable pro-
duction costs (labor) and increases the level of overhead required to pro-
gram and maintain the additional equipment regardless of variations in
output (or sales). The extent to which the firm incorporates fixed costs in
their production operations is captured as the degree of operating leverage.
Accordingly, we characterize firms that have high labor intensities as low
operating leverage firms: Firms that have high capital intensities are char-
acterized as high operating leverage firms.

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 Working Capital Management: A Business Approach

The fixed expenses of the firm are typically composed of selling, gen-
eral, and administrative (SGA) expenses. Thus, we expect to see an in-
crease in SGA expenses over time as firms increase their capital intensity.
We would also expect to see a decrease in the proportion of variable ex-
penses (labor and materials) relative to fixed expenses as firms increase
their degree of operating leverage for any given level of sales (output).
It is important to note that not all fixed expenses are incurred as a re-
sult of the increase in capital intensity. We suggest that changes in SGA
expenses tend to be a good proxy for changes in the level of fixed expens-
es associated with increases in capital intensity. The possibility exists that
changes in the degree of operating leverage may not be due to changes in
the firm's production function. Instead, changes in the degree of operating
leverage may simply be driven by an increase in the administrative over-
head of the firm or changes in sales. In fact, changes in the level of sales

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over time may make it appear that the firm is altering its operating lever-
age. This result obtains in part because cost of goods sold tend to vary as
sales vary whereas selling, general and administrative expenses tend to

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vary less than sales.

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We generally assume that any increase in capital intensity will result in
an increase in fixed costs and a concurrent decrease in variable costs. De-
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creases in variable costs may result from a decrease in the use of labor, a
decrease in the scrap rate due to better equipment or a combination of the
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two. During the 1980's and into the decade of the 1990's many U.S. and
foreign firms were busy increasing the capital intensity of their production
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functions in efforts to become more efficient producers as well as achiev-

ing low-cost higher-margin operations. In the global marketplace, produc-
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tivity is a potent competitive weapon in the hunt for market share and
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market dominance. As a consequence of this activity we observe a gen-

eral increase in the degrees of operating leverage for most businesses.
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Estimating the Degree of Operating Leverage

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The degree of operating leverage (DOL) is estimated using income state-

ment data. The accounting data relationship is defined in equation 9.1:

DOL = Gross Profit / Operating Income (9.1)

Gross profit is defined as net sales minus the cost of goods sold. Gross
profit reflects the impact of variable costs on the cash flow of the business.
As firms become more efficient or capital intensive, we expect to observe
a decrease in the variable cost rate and a concurrent increase in gross prof-
itability. Operating income is defined as gross profits minus selling, gen-
eral, and administrative expenses (SGA). We observe that operating in-
come is subject to the effects of variable as well as fixed (SGA) expenses.
However, since the relationship uses the gross profit amount in the numer-
ator and the operating income in the denominator, the DOL measures the

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 Working Capital Management: A Business Approach

impact of fixed costs on operating profitability. Table 1 illustrates how

the DOL is computed'

Table 1
Net Sales $ 100.00
Cost of Goods Sold 40.00
Gross Profit $ 60.00
Selling, Genl. & Admin. Expenses 30.00
Operating Income $ 30.00
Degree of Operating Leverage 2.00

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The DOL value of 2.00 suggests that the firm requires $2.00 in gross prof-
its to generate $1 in operating profits after fixed expenses are paid.

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Changes in DOL Unrelated to Production Function Changes

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As suggested earlier, the DOL is affected by changes in the production
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function, changes in the level of sales, and changes in SGA expenses unre-
lated to the production function. In this section we explore the effects of
changes in sales volume and changes in SGA expenses on the DOL as the
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production function is held constant. We simulate holding the production
function constant by maintaining the variable cost rate (or slope of the var-
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iable cost curve) at 40% of sales. In accounting terms we are maintaining

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a constant contribution margin of 60%.

Table 2 illustrates how changes in sales levels can impact the DOL
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measure. Firms can experience changes in sales over time due to chang-
ing economic factors, competitor activities, and business cycles. We as-
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sume that SGA expenses remain the same ($30) as sales are increased
25% to $125.
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Table 2
Net Sales $ 125.00
Cost of Goods Sold 50.00
Gross Profit $ 75.00
Selling, Gen'l. & Admin. Expenses 30.00
Operating Income $ 45.00
Degree of Operating Leverage 1.67

Sales increased 25% while the variable cost rate remained the same; i.e.,
40% of sales or .4 times 125 equals $50. The new gross profit is $75 and

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 Working Capital Management: A Business Approach

the operating profit is $45 yielding a new DOL of 1.67. The DOL of 1.67
implies that it takes $1.67 of gross profits to produce $1.00 of operating
income. The increase in operating profitability is due to a higher level of
sales, a constant variable cost rate, and fixed SGA expenses.
The example contained in Table 2 illustrates an important observation
about the degree of operating leverage. The DOL is as sensitive to chang-
es in sales as it is to changes in the production function and the rate at
which SGA expenses are incurred. In the Table 2 scenario, the analyst
might be tempted to conclude that the firm had decrease its capital intensi-
ty or increased its labor intensity or a combination of the two as indicated
by the lower DOL. In this particular instance, the correct analysis is that
no change occurred in the firm's production function: This is because the
variable cost rate and SGA expense rate remained the same. The decline
in the DOL is due entirely to the changes in sales revenue.

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The DOL is also sensitive to autonomous changes in SGA expenses.
In the absence of detailed analysis, increases in SGA or fixed expenses
suggest an increase in capital intensity. For example, let us return to Table

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1 and simulate the effects of an increase in SGA expenses without a

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change in the firm's production function. The increase in SGA could be
mistaken for a change in the operating leverage of the firm. The simula-
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tion is contained in Table 3. In this example, the firm is assumed to have
increased its staffing levels or incurred higher SGA expense rates ($40) as
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it continues to do the same level of business. The level of sales remains
the same as in the Table 1 example.
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Table 3
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Net Sales $ 100.00

Cost of Goods Sold 40.00
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Gross Profit $ 60.00

Selling, Gen'l. & Admin. Expenses 40.00
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Operating Income $ 20.00

Degree of Operating Leverage 3.00

The DOL in Table 3 is 3.00 or $3.00 in gross profits are required to

produce $1.00 in operating profits. The DOL in Table 3 is greater than the
DOL in Table 1 suggesting an increase in the degree of operating lever-
age. However, the increase in DOL was caused by a change in SGA ex-
penses and not by a change in the firm's production function. Understand-
ing the impact of changes in the firm's fixed (SGA) cost schedule becomes
more important as we seek to analyze the effects of corporate downsizing
on the firm's operations. During the decade of the 1990's a large number
of U.S. companies have been downsizing in an effort to alter the operating
characteristics of their businesses. However, changes in the SGA expense

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 Working Capital Management: A Business Approach

schedules do not necessarily imply that production functions have

changed. The key decision input is the variable cost rate. If the variable
cost rate has changed, then we are on sounder footing with respect to anal-
ysis of changes in the DOL for a firm over time.

Effects of Changes in the Production Function on DOL

In this section we simulate the effects of a change in the firm's produc-

tion function. When firms increase their capital intensity, we should ob-
serve a decrease in the variable cost rate (or slope of the variable cost
curve). We should also observe an increase in the rate at which fixed ex-
penses are incurred. In the example contained in Table 1, the variable cost
rate is 40% and the fixed rate of SGA expenses is $30. The increase in
capital intensity (more automation) is simulated to reduce the variable cost

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rate to 35% and increase the fixed SGA expenses to $35. We make notice
that the reduction from 40% to 35% in the variable cost rate represents a
reduction of 12.50%. The increase in fixed SGA expenses from $30 to

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$35 represents an increase of 16.67%. These percentage changes suggest

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that we are experiencing diminishing returns to scale as we increase capi-
tal intensity. The Base [case] represents the initial production function and
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"∆Sales" the effects of a change in sales on operating profitability. The
expression "∆PF" represents the change in the production function via a
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capital for labor substitution. The post-production function increase in
sales, "∆Sales*", represents the impact of a change in sales on operating
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profitability after the change in the firm's capital-labor mix. The results of
this simulation are contained in Table 4.
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Table 4
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Base ∆Sales ∆PF ∆Sales*

Net Sales $ 100.00 $ 120.00 $ 100.00 $ 120.00
Cost of Goods Sold 40.00 48.00 35.00 42.00
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Gross Profit $ 60.00 $ 72.00 $ 65.00 $ 78.00

SGA Expenses 30.00 30.00 35.00 35.00
Operating Income $ 30.00 $ 42.00 $ 30.00 $ 43.00
DOL 2.00 1.71 2.17 1.81

The simulation results in Table 4 clearly demonstrate the effects of

changes in the degree of operating leverage resulting from a change in the
firm's sales revenue and changes in the firm's production function. From
the Base case scenario to the ∆PF we observe an increase in the DOL from
2.00 to 2.17. This is exactly the result we should expect when a firm in-
creases it capital intensity. As Base case sales increase from $100 to
$120, the ∆Sales DOL is 1.71. The decline in the DOL is due entirely to

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 Working Capital Management: A Business Approach

the change in sales. As the ∆PF sales increase to $120, we observe an in-
crease in the DOL from 1.71 to 1.81. The increase in operating leverage
requires more gross profits to produce a dollar of operating profits. How-
ever, we observe that for the same increase in sales, the firm generates
$43.00 in profits versus $42.00 in the base case scenario. This increase in
profitability is due to the increase in capital intensity or increase in operat-
ing leverage. Firms are motivated to increase their capital intensity until
that point where an increase in capital does not result in an increase in
profitability.
These simulations serve to remind the financial analyst that changes in
a firm's DOL must be carefully examined to determine the exact reason
for the change. Herein we identified three possible explanations for why
we might observe changes in a firm's DOL over time. In order to verify
the cause other information must be brought into the analysis such as the

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variable cost rate and a detailed analysis of the changes in SGA expenses.

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An Alternative Method of Estimating the DOL

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The DOL computed in the previous sections are point estimates.
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There is a second algorithm that yields a range estimate. The term
"range" is used to denote the fact that we must use two years of data rather
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than one as was previously the case. The degree of operating leverage is
estimated using the change in operating income divided by the change in
sales. Equation (9.2) specifies the relationship:
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DOL = % change in operating income / % change in sales (9.2)

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Where:
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% change in OI = [(OIit - OIt-1) / OIt-1] * 100

% change in Sales = [(Salest - Salest-1) / Salest-1] * 100
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t, t-1 = time indexes to represent current and previous year

Table 5 contains two years on income statement data that will be used to
demonstrate the DOL range estimate.

Table 5
Year 1 Year 2
Net Sales $ 100.00 $ 120.00
Cost of Goods Sold 40.00 42.00
Gross Profit $ 60.00 $ 78.00
SGA Expenses 30.00 35.00
Operating Income $ 30.00 $ 43.00
DOL 2.17

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 Working Capital Management: A Business Approach

The percent change in operating income (%∆OI) is:

%∆OI = [(43 - 30) / 30] * 100 = 43.33%

The percent change in sales (%∆Sales) is:

%∆Sales = [(120 - 100) / 100} * 100 = 20.00%

The DOL is:

DOL = 43.33% / 20.00% = 2.17

This is the same estimate we obtained in Table 4 for the base case, after
the production function was changed. If we use the sales figures for the

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original scenario in Table 4, the range DOL is 2.00 (40.00% / 20.00%).
Assuming the production function does not change in the second year, the

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range (2-year) DOL will yield the same value as the point estimate for the
base (first) year. The DOL of 2.17 suggests that we must generate $2.17

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in sales in order to generate an additional dollar of operating income.
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Estimating DOL when Unit Prices and Costs are Known
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Up to this point, the algorithms utilized for estimating the DOL have
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relied on data from the income statement. It is possible that the inside fi-
nancial analyst will have access to discrete product information such as
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unit selling prices, variable costs per unit and the total fixed costs associ-
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ated with a particular product. This information can be used to compute

the DOL and the break-even point (BEP). Equation (9.3) specifies the re-
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lationships:

DOL = Q (P - VC) / [Q (P - VC) - FC] (9.3)

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Where:
Q = Quantity of output
P = Price
VC = variable cost per unit
FC = fixed costs

Suppose a particular product sells for $27.00 and has a variable cost per
unit (labor and materials) of $15.00. The fixed costs associated with this
process are $390,000. The company expects to sell 60,000 units in the
coming year. The DOL is:

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 Working Capital Management: A Business Approach

DOL = (60,000*(27 - 15)) / [60,000 * (27 - 15) - 390,000]

DOL = 720,000 / 330,000 = 2.18

This last algorithm expresses the required increase in gross profits

($2.18) in order to generate $1.00 of additional operating income.

Breakeven Point Analysis

An important part of any profitability analysis is determining the point at

which the firm will breakeven. Breakeven is defined as the point where
operating income is zero. Expressed as an accounting identity, the break-
even point (BEP) is defined in equation (9.4):

BEP = Sales - Total Variable Costs - Total Fixed Costs = 0 (9.4)

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Variable costs include labor and materials; fixed costs include selling,

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general and administrative (SGA) expenses. The current specification ex-
cludes all non-cash expenses as well as non-operating expenses such as

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interest expense and taxes as well as non-operating sources of income
such as interest income on short-term investments. The breakeven rela-
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tionship may also be expressed as shown in equation (9.4'):
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BEP = Total Revenues - Total Costs (9.4')
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Figure 9.1 expresses the relationship in graph format:

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Figure 9.1: BEP Graphical Analysis

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The BEP occurs where the Total Cost curve (TC) crosses the Total Reve-
nue (TR) curve or the point at which TR = TC. Operating profits occur
when total revenues exceed total costs (operating expenses): i.e., TR > TC.
Operating losses occur when total revenues are less than total costs; i.e.,
TR < TC. The variable cost curve begins at the fixed cost intercept and

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 Working Capital Management: A Business Approach

rises as output rises. The implicit assumption in BEP analysis is that no

variable costs are incurred if output is zero. However, that does not mean
that the firm is not incurring fixed costs. Intuitively speaking, firms are
incurring costs before the door is opened for business. Drawn in this
manner (straight lines), the variable cost line also defines the total cost
curve.
As firms increase the capital intensity, vis-à-vis their labor intensity,
the fixed cost line moves up to a higher intercept while the slope of the
variable cost curve declines. The result is an increase in operating lever-
age and a concurrent increase in the breakeven point. Figure 9.2 reflects a
high capital intensity - high DOL - firm.

Figure 9.2: High Capital Intensity Firm

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Figure 9.2 suggests a firm with a much higher degree of operating lever-
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age than the firm depicted in Figure 9.1. The higher DOL is associated
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with a higher BEP. The high DOL firm must sell more output in order to
breakeven. Less obvious is the observation that the angle formed by the
TR and TC curves in Figure 9.2 is greater than the angle in Figure 9.1.
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This difference implies that once a firm achieves breakeven point, high
DOL firms accrue greater incremental increases in operating income for
similar increases in sales when compared to firms with a lower DOL.
An important implication of DOL analysis is that firms planning to
increase their operating leverage need to be certain that they will be able
to sufficiently exceed the new BEP level in order to accrue the benefits of
increased operating leverage.

Estimating BEP when Unit Prices and Costs are Known

We can compute the BEP for a single product process using equation
(9.5):
BEP = FC / (P - VC) (9.5)

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 Working Capital Management: A Business Approach

Where:
Q = Quantity.
P = Price.
VC = Variable Cost (COGS).
FC = Fixed Costs. (SGA less depreciation).

We compute the BEP using the problem data from the earlier DOL exam-
ple: i.e., P = $27, VC = $15, and FC = $390,000. The BEP for this pro-
cess is:

BEP = 390,000 / (27 - 15) = 32,500 units

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If the firm sells exactly 32,500 units, it will generate 32,500 * (27 -15) in
contribution or $390,000 which is exactly equal to the fixed costs of

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$390,000. Very few processes involve a single product. However, the

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procedure may be generalized to a multi-product environment by adding
up the discrete cost structures. The result of this addition is a composite
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estimate of the firm's DOL and BEP.
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BREAKEVEN POINT ANALYSIS IN PRACTICE
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Financial managers must have an idea of what level of sales the firm must
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achieve in order to meet their cash expenses. Sales above the BEP should
yield operating profits. Operating profits must in turn be sufficient to ser-
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vice debt, pay the necessary taxes, and result in an amount sufficient to
generate a suitable return on invested capital. The firm's cost structure is
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partly a function the labor-capital intensity ratio and the efficiency of or-
ganizational structure and internal controls. Accordingly, there are a vari-
ety of possibilities. Two companies in the same business and with the
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same level of sales may have radically different BEP depending on the
DOL and the makeup of their production functions. Ultimately, firms
come to market with two things: their marketing acumen and their cost
structures. The later reflect the company's production function. The im-
portant idea is to control costs while producing a good quality product.
The firm's production function is largely unobservable. The results of
the firm's production function and efficiency of management are to be
found in the financial data comprising the annual report. Income state-
ments are utilized to compute a variety of financial ratios as well as the
DOL and BEP as demonstrated earlier. The BEP may be estimated using
equation (9.6):

BEP = SGA / GPM (9.6)

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 Working Capital Management: A Business Approach

Where:
SGA = Selling, General and Administrative Expenses
GPM = Gross Profit Margin = Gross Profit / Net Sales

Equation (9.6) gives the BEP in sales dollars. The BEP in units may be
computed using equation (9.7):

BEP = SGA / Contribution Margin (per unit) (9.7)

Contribution margin is defined as the difference between the selling price

and the variable cost per unit. In an earlier example, price and variable
cost per unit where known. In reality, the contribution margin is analo-
gous to gross profit. Accountants also use the term contribution margin

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ratio that means exactly the same as gross profit margin. The astute fi-
nancial analyst should never confuse the accountant's use of the expres-
sion contribution margin with the financial analyst's use of the expression

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gross profit margin: The two expressions are dramatically different even

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though they refer to the same line on the income statement. The former is
a dollar amount, the latter a percentage. If the financial analyst has the
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contribution per unit, then equation (9.7) may be utilized to determine the
BEP in units.
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Accounting versus Cash Breakeven Point

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Firms on the edge of financial problems will need to know the level of
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sales necessary to sustain operations until profitability from higher levels

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of sales can be achieved. In all of the examples in this chapter, SGA ex-
penses have not included depreciation expenses. The reason for this omis-
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sion is that depreciation is a non-cash expense. Depreciation expense is

important for two reasons. First, it shelters a portion of the firm's cash
flow from taxation. Second, depreciation expenses also provide a pool of
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cash flow from which we finance the necessary reinvestment in the firm's
existing asset structure to maintain its productive quality (capital mainte-
nance). In those instances when depreciation expenses have been included
in the SGA totals, they must be backed out before any meaningful cash
breakeven point may be identified.

SUMMARY

The profitability of the firm is characterized as a function of its total cost

structure. The total cost structure is comprised of variable costs (labor and
materials) and fixed costs (selling, general and administrative expenses).
The mix of variable and fixed costs reflects the firm's production function.
The firm's production function is largely unobservable. As a consequence,

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 Working Capital Management: A Business Approach

the financial analyst must use the degree of operating leverage as a proxy
measure of the firm's mix of capital and labor. In their drive to be compet-
itive, firms are motivated to be as efficient as possible. The most typical
path to economic efficiency in an industrial economy is to be a capital-
intensive producer.
The substitution of capital for labor is the hallmark of modern indus-
trial companies. By increasing capital intensities, firms decrease the slope
of the total cost curve. They pay for the reduction in slope by increasing
their fixed cost structure. The desired outcome of this transformation is
increased operating efficiency and a more competitive stance in the global
market.
The financial analyst has two methodologies for identifying the deter-
minants of the changes in a firm's profitability. The analyst can attempt to
determine the exponents of the production function or she can use changes

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in the degree of operating leverage as an approximation of changes in the
firm's production function. While the former approach is more difficult
analytically speaking, the latter's ease of application is fraught with poten-

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tially erroneous conclusions. As demonstrated earlier, DOL may change

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simple as a consequence on new levels of sales rather than a more funda-
mental change in the firm's production function. Moreover, autonomous
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changes in the firms SGA expense structure may lead to erroneous conclu-
sions as to the true nature of the production function. Accordingly, any
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conclusions about the firm's strategy based on DOL measures must be
confirmed by examining other ratios.
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A final issue I the dealing with the effects of inflation over time. The
DOL ratios examined in this chapter are relatively unaffected by inflation.
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This is because we find that inflation affects the numerator and denomina-
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tor in near equal measure thus canceling the impact on inflation on the
DOL measure. The only exception is the BEP. Over time, inflation may
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cause the BEP to rise irrespective of any changes in the firm's production
function. Ultimately, the best strategy is to work with a deflated data set
(nominal yearly values expressed in constant dollars) in order to analyze
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changes in the firm's labor-capital ratio.

QUESTIONS AND PROBLEMS

1. The availability of financial data for publicly held companies is quite

extensive. One really good source is the Compustat Data Base available
by subscription in most business schools. Select a few companies in the
same industry and compute the degree of operating leverage for each year
of data. What strategies can your discern from analysis of the financial
data?

2. Chapter 8 presented a methodology for estimating a firm's production

function based on the cost of goods sold and the net plant, property and

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 Working Capital Management: A Business Approach

equipment balances. Select a few companies in the same industry and es-
timate the firm's Cobb-Douglas production function parameters in differ-
ent sub-periods. Compare the results of this analysis to that obtained in
question #1 above. Optimal results will be achieved if each sub-period
has at least 8 to 10 years of data to estimate the labor and capital coeffi-
cients.

3. The literature on the manufacturing strategies of industrial firms on

rare occasions will discuss or describe changes the firm is making in order
to become more efficient and more profitable. Using internet or library
resources, identify some strategies being pursued by different manufactur-
ing firms and how you would verify the results.

4. Changes in the variable cost ratio are important confirmatory pieces of

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information for determining when companies have altered their capital-
labor intensity ratios. Collect a series of variable cost ratios and see how
they correlate with concurrent point estimates of the DOL.

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