Capital, Leverage

Discussing concept of operational leverage in managerial accounting class. Mathematically being contribution margin/operating income. Idea that the higher the operating leverage, the more significant the effect of a percentage change in gross income. A business with high operating leverage having a significantly higher operating income, relative to a percentage change in gross revenue, if operating leverage is high. High operating leverage generally associated with capital-intensive businesses. Thus, a justification for fewer workers and more machines.

Downside is that firms with higher operating leverage also have more profound reductions to operating income, relative to a percentage decrease in gross revenue. Hence the high failure rates of capital-intensive firms in times of economic downturn. Fewer workers, but greater prospect of layoff.

Labour-intensive businesses considered to be more flexible and resilient in times of economic uncertainty, due to lower operating leverage. The income doesn’t go as high in positive economic times, but income also doesn’t go as low in negative economic times.

Once had a student who owned a 200-person factory in China. Unclear what the capital structure of the business was. Student had few concerns about economic downturns. Said he would simply lay off workers in down times. Where the point is that the down times are not as harsh for companies with lower operating leverage, compared to companies with high operating leverage. High operating leverage being one “rust belt” explanation. The mass layoffs in the auto industry. Also why law firms with high capital costs end up laying off proportionately more lawyers in a recession.

Since economic times are generally uncertain…turning towards more labour intensity, in the interest of firm flexibility and longevity?

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About brucelarochelle

Practising Lawyer and Part-Time University Instructor (Accounting, Commercial Law, Organizational Behaviour); Part-Time Federal Tribunal Member. Non-practising Chartered Professional Accountant (Chartered Accountant and Certified Management Accountant).
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