Operating Leverage (Fixed vs. Variable Costs)

Read the following and answer the question at the end. As managers, we are focused on maximizing shareholder value. Now, one thing that will surely impact shareholder value is if we declare bankruptcy. We can go under in the traditional way, by losing enough money that we have negative equity, i.e., our liabilities are greater than our assets. However, we can also go bust in a less spectacular way, by running out of cash, and being unable to make timely payments on our bills. With this in mind, a company constantly makes decisions on how to engineer its business operations, choosing between fixed costs and variable costs of production. Fixed costs are largely independent of the current level of our business: the lease payment on the distribution center is the same whether we’re shipping at maximum capacity, or it is absolutely idle. Conversely, we only pay the outside trucking service based on actual shipments. When we automate a manual process, we typically are converting variable expense (labor) into fixed expense (systems, hardware, one-time programming). We are adding fixed expenses (rent, equipment maintenance, etc.) that need to be paid, regardless of how well or poorly we perform. The relative degree of fixed vs. variable costs is referred to as operating leverage. **What kind of risk-reward thinking should go into this decision? How does this translate into a manager’s day-to-day decisions?

#Operating #Leverage #Fixed #Variable #Costs

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