Tag Archive | Profit volume

Operating leverage explained

Operating leverage refers to relative amount of costs that are fixed and variable in the cost structure of a business. Some companies will have relatively high fixed costs compared to variable costs and are said to have a high operating leverage. For example, pharmaceutical companies incur up to $1billon to develop new drugs over a 10 to15 period[1], whereas the manufacture cost pennies – just think of the price of a pack of paracetemol in your local pharmacy. Low operating leverage means variable costs are a relatively high proportion of total costs. Retailers like Tesco or Sainsbury have relatively low fixed costs and relatively high variable costs – the variable cost of each item sold (e.g. the purchase price) is likely to be much higher than the associated fixed cost for that item. The degree of operating leverage of a company can be used to assess its risk profile. Companies with high operating leverage are more vulnerable to decreasing sales e.g. sharp economic and business cycle swings. Companies with a high level of costs tied up in machinery, plants and equipment cannot easily cut costs to adjust to a change in demand. So, if there is a downturn in the economy revenues and profits can plummet. On the other hand, companies with lower operating leverage can adapt their cost structure more rapidly as it has more variable costs.

[1] http://www.washingtontimes.com/news/2009/mar/13/blocking-drug-development/ accessed  Dec 4th, 2009

The profit volume relationship – an important lesson for any business

Tracey Taylor writes in the NY Times (Apr 7, 2010) about a US design and build company, mkdesigns. The company designs and builds prefabricated, environmentally friendly homes. The founder, Michelle Kaufmann, decided in 2006 to buy or build a factory as she could not find producers willing to form a strong business alliance to deliver quality product on time.  The reason for this? Simply, it was 2006 – the top of the construction boom in the US (and Europe). Kaufmann acquired one factory, then another, which increased the businesses cost base.  Higher sales volumes were needed to cover the increased costs and maintain profits. Then, the bust came in 2008, sales volume declined and the business had to close its two factories.  The basic lesson here is that a certain level of sales are needed to cover costs; increase costs without a corresponding increase in sales an your business is in trouble . Read the full article here –My Green Prefab Business, and How It Once Grew – NYTimes.com.

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