Concept Note---Operating Leverage.

Services firms are generally characterized by having a higher fixed costs

relative to their variable costs. There are exceptions, but these exceptions
are seen only in the retailing industry (aka Wal-Mart)
A firm is said to be highly leveraged if fixed costs are large relative to
variable costs. For example, relatively large fixed costs may result when the
firm has large amounts of investments into fixed assets (Plant and M/c and
also labour costs especially if the firm works in an environment where hire
and fire policy is difficult to implement aka. India, France, China, and some
other European countries)
A general characteristic of highly leveraged firm is that it faces more
variation in profits for a given % change in sales compared to a less
leveraged firm. Why? Because the total cost for a highly leveraged firm will
change less than in proportion to a change in sales (or the output rate), and
therefore, profit will tend to change more in proportion to changes in sales
(or the output rate)
Leverage can be analysed using the concept of profit elasticity (

),

defined as the percentage change in profit associated with 1 percent change

in unit sales (or rate of output). That is,
E =

change profit
changeunit sales ------------1

Or

Q
E =
=
.
Q Q -----------------------2
Q
For infinitesimally small changes in Q, the profit elasticity is
E =

d Q
.
dQ

------------------3

If the Price of the output is constant regardless of sales, profit elasticity

depends on three variables, unit sales, the total level of fixed costs and
variable cost per unit. This can be seen by substituting the equations for
profit
=PQ( AVC ) QTFC -------------------4
And change in profit is
=P ( Q ) ( AVC ) Q --------------------5

If we put this in the equation no. 2, then

[P ( Q ) AVC ( Q )]
[ PQ( AVC ) QTFC ]
E =
Q
Q

-------------------------6

Simplifying the above equation we get

E =

Q(PAVC )
Q ( P AVC )TFC -------------------------------7

If you closely inspect this equation, you will see that two firms having equal
prices, unit sales, and variable costs per unit, the firm having greater fixed
costs will have a higher profit elasticity. This is because the fixed cost is in
the denominator with a negative sign, i.e. higher the fixed costs, lower the
denominator and therefore higher the profit elasticity.
What is the effect of this?
1. A small drop in sales will lead to a relatively higher drop in profits.
Infact, the 1st signs of recession is seen in the trucking industry. When I
was working in GE Capital, a general thumbrule that was used to see
the condition of the economy is to stand on the highway and check for
new trucks to old trucks ratio. If this ratio was les than 0.3, then the
economy was in trouble.
2. Also the above thumbrule was used to check if the economy was
bouncing back!
3. Pricing becomes a huge challenge. Normally, economics profs. Will tell
you that the firms prices should be above the variable cost per unit

(which is called contribution, if you closely look at equation 7, (P-AVC)

is called the contribution). If the contribution is positive, over time it
will cover for the TFC, and the firm makes a profit. In services firms this
rule does not hold since variable costs are almost zero (or very small
compared to fixed costs) and therefore, ones volumes has to be huge
to breakeven (or even make profits)
4. A corollary to observation no. 3 is the propensity of services firms to
keep tapping into newer segments with the existing resource to
increase the scale of operations. For example, in XLRI, faculty is a fixed
resource. With the same fixed resource the institute tries to tap into
Satellite programme, GMP programme, Dubai, MDP, In-company,
International Programme, increase number of BM and HRM students
etc. You will see this trend in almost all cases that we will deal with!
Hope all this makes sense.
Regards,
Raj