Organizations that have high levels of fixed costs , can capitalize on the concept called operating leverage. The higher the fixed cost, the greater the potential for operating leverage. Wikipedia defines Operating Leverage as a measure of how revenue growth translates into growth in operating income, a measure of leverage, and of how risky (volatile) a company’s operating income is.
There are two type of costs in a business. Those costs that are incurred with time, such as property, vehicle or plant rental, leases, insurance etc. and those costs that are incurred with output, such as direct or variable costs.
The greater the level of output, the lower the cost per unit produced are in respect of fixed costs. This is because the total fixed costs are spread over more units produced. Conversely, variable costs remain fixed per unit and increase in total with each additional unit produced. The greater the level of output, the higher the total variable costs. Therefore, fixed costs have an inverse relationship with increasing output, whilst direct or variable costs have a direct increasing relationship with increases in output.
Industries with high levels of fixed costs, such as mining, manufacturing, heavy industrial engineering, construction etc. can capitalize on maximizing operating leverage. The break-even chart below graphically illustrates how small increases in volume above break-even point, generate a leverage of profits. (see green are of graph below).
The vertical axis represents sales and costs. The horizontal axis represents unit volume of output sold. Both axis start at zero (0).
The straight horizontal axis intersecting the sales and cost axis at $20K represents the fixed costs that the business need to incur even if it doesn’t produce one unit of product. Fixed costs are valid for a given volume of output. In the above example, it is 2,000 units. Above 2,000 units, this enterprise may need to invest in more space, more people and more plant etc. to increase its production and sales. Therefore, above an output of 2,000 units, fixed costs would increase as a step function, say to $25k or $30k. The new level of fixed costs will enable the company to produce to a higher level until production becomes constrained, at which time, the company will have to invest in another ‘step’ of fixed costs.
If the organization does not sell one unit, it will incur a loss of $20,000 as shown by the bracket marked ‘Loss’ (representing the fixed costs. If it sells one unit, the total fixed cost of $20,000 will be absorbed by the single unit produced. As volume increases, so the $20,000 is apportioned over the increased volume and the cost per unit produced decreases. In the above example, the fixed cost per unit will be $10,000/2,000 = $5 per unit.
In addition to the fixed costs, every organisation incurs variable or direct costs. In the above chart, the variable costs are $5 per unit (At an output of 2,000 units, the variable costs are $10,000 i.e. $30,000 minus the fixed costs of $20,000. Therefore, the cost per unit is total variable costs/output produced i.e. $10,000/2,000=$5). The variable costs is static per unit produced and increases with volume.
The total cost is determined by adding the fixed costs to the total variable costs at any level of output. Mathematically, the total cost at an output of 2,000 units is fixed cost per unit plus variable cost per unit i.e. $10+$5=$15 per unit. The total cost will be $15×2,000=$30,000. (See above example).
The sales line starts at the origin (i.e. the intersection of the Sales and Cost axis with the Volume axis). In the above example, total sales is calculated by multiplying the volume sold by the sales price 2,000 x $25.00 = $50,000.
All sales below the break-even point will incur a loss. When the sales hit break-even point, neither a loss is incurred, nor a profit is made. Above break-even volume, profits are earned at a multiple of the increased volume. The break-even point is calculated as follows:
Fixed Costs/Contribution %
= Fixed Costs/(Sales per unit – Variable costs per unit/Sales per unit X100)
= $20,000/(($25.00 – $5.00)/25,00 X100))
= $20,000/80.0% = $25,000 (See above graph)
Sales of $25,000/unit selling price of $25.00 each = break-even volume of 1,000 units
The Multiplier Effect (TME) = Contribution (C)/Profit (P)
At a volume of 100 units above break-even, TME=11.0 times
TME reduces as volume increase. So at a volume of 2,00 units, TME= 2.1 times
How to Boost Profits Above Break-Even
The objective is to increase the outputs with the same or less effort on the inputs and without compromising the quality of the outputs. We can do this in several ways:
1. In a relatively price inelastic market, increase your selling price without entertaining any increase on material or labor inputs. In the above example, a 1% increase in selling price, whilst holding all other variables constant, will result in a multiplier effect of 2.5 times
2. Increase productivity and efficiency so that the volume of production increases for the same total cost. This can be achieved by applying any one od several proven continuous improvement methodologies. For example, you can re-engineer all your processes or you might apply the Theory Of Constraints (TOC). . In the above example, a 1% increase in volume, whilst holding all other variables constant, will result in a multiplier effect of 2.0 times.
3. Reduce your fixed costs to lower your break-even point. This can be accomplished by reviewing each fixed cost line item by line item to explore ways in which to reduce, eliminate or contain that cost. During the continuous improvement process, other possibilities for removing costs from the system or containing them may be highlighted. In the above example, a 1% reduction in fixed costs, whilst holding all other variables constant, will result in a 1% increase in profits. This shows the relative futility of focusing on cost reduction to the exclusion of everything else. Rather, focus on increasing revenue.
4 Reduce variable costs to increase your contribution percentage. This can be accomplished by critically evaluating everything you do to add value to your inputs. See Business process re-engineering and TOC above. In the above example, a 1% reduction in variable costs, whilst holding all other variables constant, will result in a 1/2% increase in profits. This is because the variable costs are already very low relative to the selling price. Any further reduction in variable costs will create a marginal profit improvement. Again, rather focus on increasing revenue.
Students of the Victorian University in New Zealand undertook a study of over 100 organizations across several different industries that had applied the Theory of Constraints (TOC) to their businesses. The results were astounding. No failures were reported. Here are the top line findings:
1. The mean revenue to throughput increase was 68% (after removing outliers)
2. The mean reduction in inventory levels to service the increased volumes was 50%
3. The mean reduction in lead times was 69%
4. The mean increase in due date performance was 60%
5. Profits were boosted by 82% around the mean
The Operating Leverage lessons are that any company can Boost its Profits by focusing on the areas that will deliver the greatest multiplier effect. Management needs to undertake the analysis before jumping into initiatives that will, at best, deliver mediocre results