Financial Leverage arises because of a Fixed cost of production b Variable Cost

Fixed Cost
A business expense that is not dependent on the level of goods or services produced by the
business. Expertise in manufacturing is expertise in using expensive resources efficiently and process improvement; retailers outsource production. We also discuss the shortcomings of these papers, identify the gap(s) in the literature, and point out how our paper addresses these gaps.

One measure that doesn’t get enough attention, though, is operating leverage, which captures the relationship between a company’s fixed and variable costs. In this lesson, you learned that operating leverage is defined as the degree to which a company’s
operations rely on fixed costs (such as machinery) versus variable costs (such as workers). As
operating leverage increases, more sales are needed to cover the increased fixed costs. However,
once fixed costs are covered, profitability increases more quickly for a given increase in sales. Lederer and Mehta (2005) study the capacity decision under uncertainty, incorporating risk-adjustment (in a CAPM setting) and the interaction between risk and scale.

Financial Leverage

In fact, the relationship between sales revenue and EBIT is referred to as operating leverage because when the sales level increases or decreases, EBIT also changes. The degree of financial leverage (DFL) increases directly with increased borrowing. You want to beat out the competition on price, so you sell your coffees pretty low at
$1/coffee. It seems almost heretical to say, but fixed manufacturing capacity and capability (i.e. fixed costs) are the essence of a long-term competitive advantage for a manufacturer.

For example, airlines have high operating leverage because the cost of carrying an additional passenger on a plane is quite low. Much of the price of a restaurant meal is in the ingredients and labor, meaning they’ll have low operating leverage. The biggest risk that arises from high financial leverage occurs when a company’s return on ROA does not exceed the interest on the loan, which greatly diminishes a company’s return on equity and profitability.

Leverage Models

The key determinants of DOL are identified as costs (fixed cost, variable cost, and cost of capacity), demand characteristics (growth, volatility, and price-sensitivity), productivity of capital, and interest rate. However, the exact impact of these factors depends on whether the timing of investment is exogenously specified or endogenously determined by the company, because investment timing has a significant impact on DOL. For instance, DOL is an increasing function of capital productivity for exogenous timing but a non-monotonic (U-shaped) function for endogenous timing. We also get some surprising results; for instance, when investment timing is exogenously specified, DOL is an increasing function of variable cost and volatility (business risk), both of which are counter-intuitive, as discussed in section 3.3. These relationships stem from the capacity choice decision and the implicit option embedded therein. Recall that variable costs are those that change alongside the volume activity of a business, andfixed costs
are those that remain constant regardless of volume.

• After its fixed development costs were recovered, each additional sale was almost pure profit.
• How a business makes sales is also a factor in how much leverage it employs.
• Activity-based costing has a tendency to make all costs appear variable and should be used with caution to ensure the fixed and variable nature of costs are accurately reflected.
• For example, airlines have high operating leverage because the cost of carrying an additional passenger on a plane is quite low.

After being in
business for one year, you have spent a total of $100,000 acquiring the fixed assets you need,
including a small location, coffee machines, grinders, chairs, tables, and other random necessities. A we already know that the degree of operating leverage depends on the fixed overhead in the total cost structure of a firm. The simplified version of equation of the equation reveals that the change
in owners’ rate of return resulting from a change in the level of output is not
affected by interest expense. In his 1997 article, Rushmore says that positive operating leverage occurs
at the point at which revenue exceeds the total amount of fixed costs. Yes, industries that are reliant on expensive infrastructure or machinery tend to have high operating leverage.

Operating Leverage, Profitability and Capital Structure

Insourcing provides the options to reduce the fixed cost structure (the reduce FC option), reduce the variable costs (the reduce VC option), or reduce both through process improvement, innovation and investment. Unless you have tremendous leverage, outsourcing contracts typically don’t pass those savings along, and you are, therefore, limited in your responses to competitors’ actions. Shrieves (1981) is an early attempt at identifying the optimal DOL based on the firm’s production decisions. He shows that production technology, business risk (uncertainty) and the firm’s operating decisions all have a significant impact on DOL. The Shrieves model is incomplete because it ignores the firm’s investment decision, and assumes that DOL is completely determined by production decisions.

Problems can arise if a company has very high fixed costs, and if a company has difficulty selling enough units
to break even on a particular investment. This is referred to as “business risk,” since it arises from the inherent
risk of doing business. In other words, the uncertainty of operating leverage arises because of generating a necessary amount of sales is a dilemma
all businesses face. Just as the use of operating leverage can lead to greater profits, if a company is able to
reach a given break-even point, so too can the use of leverage drastically multiply losses if that point is not
reached.

Company

Therefore, operating leverage is used much
more than financial leverage for these types of firms. Therefore, even a small error made in forecasting sales can be magnified into a major error in forecasting cash
flows. The reality is that both investment and production decisions have a significant impact on DOL.

While production decisions are certainly important determinants of DOL, investment decisions such as timing and capacity also play a key role. Therefore, any analysis of DOL that ignores investment decisions will be incomplete. We compute optimal DOL with a wide range of input parameter values, and the computed DOLs are found to be similar in magnitude to empirical estimates.