Relationship Between Operating Leverage and Financial Risk

All strategic investment decisions are going to involve some degree of risk. Risk entails not only the profitable versus unprofitable dichotomy, but also the variability in earnings or losses emanating from an investment project. One dimension of the risk-management question is captured in the concept of operating leverage.

Operating leverage is the degree of magnification of earnings or losses (expressed as cash flows or profits) set off by different levels of output. The magnification results from the variable cost versus fixed cost mix in an investment period. Generally the higher the level of fixed commitment in relation to variable costs, the greater is the leverage (and magnification). This, of course, is the central notion in the familiar break-even analysis, where concern is given not only to the break-even point, but also the levels of earnings or losses around it. Operating leverage is a double-edged sword, however. Like financial leverage, operating leverage magnifies results, making gains look better and losses look worse. If firms sales decrease by one percent, its profits will decrease by more than one percent, too. Hence, the degree of operating leverage shows the responsiveness of profits to a given change in sales.

Operating leverage becomes a strategic issue because it affects such things as variability of anticipated sales, competitive strategy, and the degree to which the firm can absorb or tolerate variations in earnings. The fact that differences exist across companies in their relative amounts of operating leverage may be largely a function of the industry in which each of them competes. The consumer goods industry, for example, tends to display a good deal more demand volatility than does the beverages industry. The first, therefore, tends to be more labor (variable cost) intensive than the latter in its production processes (though there are other explanations for this difference as well). It is much more difficult to reduce fixed than variable commitments than in the short term to address temporary demand shortfalls.

Second, a firm’s fixed versus variable cost mix is often a function of the competitive advantage it is trying to achieve. A firm choosing a technological leadership role would likely have comparably large fixed commitments to research and development. This would raise its relative break-even point and magnify the levels of losses or earnings at other output levels or a firm trying to maintain a price leadership position might require automated (capital-intensive) production systems. Here lower total costs at higher output levels allow the competitive price advantage and magnify earnings above break-even volume. Below break-even volume, the reverse is true.

Finally, the tolerance for, or ability to absorb, earnings fluctuations affects the operating leverage profile. A marginal firm, intolerant of losses, would probably make as few fixed commitments as possible. Though this might impair its upside earnings capability, the firm’s primary concern would be with downside risk. Managers are also concerned with the degree of operating leverage when confronted with vertical integration decisions, since they usually represent the conversion of variable costs to fixed costs. One reason for integrating vertically is to capture the margins realized by suppliers or downstream distributors. But in the process, additional fixed costs are normally incurred that alter the degree of operating leverage the integrator experiences. Any resulting variations in earnings or loss potential must be consistent with overall financial performance goals. If not, the new acquisition might operate at a loss (below break-even). Losses could be avoided by margin/cost trade-offs between integrated units (absorption), or additional fixed-cost commitments may be simply insignificant in the grand scheme of things.

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