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ix.                A note on operational leverage and breakeven point:

 

Assume that in order to generate wealth, your operational cycle is incurring fixed costs of F for its machinery and a variable cost of v for each unit produced. Also assume that the selling price of a unit is p. We neglect the impact of the value added tax, i.e. we assume that we realize a variable margin of (p-v) per unit sold. In this situation, if we call n the number of units produced, we will break even when:

 

Total Variable Margin >= Fixed Costs

n*(p-v) >= F

n*(p-v) >= F

n >= F/(p-v)

 

This tells you that once you are producing more than n units, you reach what is commonly called the “operational breakeven point” and your operations start making money (which does not mean that your business is in good health, because it needs to generate enough money in order to meet the investors’ expectations of returns in terms of the interests paid on debt and the income going to shareholders).

 

Let’s now turn on to analyze what happens to the breakeven point when we increase fixed costs, that is when our company is having a more aggressive investment policy. In this case, from the above inequality we can infer that the breakeven point increases: it will therefore take longer time for your operations to generate wealth.

 

If such is really the case, then why would some companies want to invest more than others ? Because investing more provides you with state-of-the-art equipment, which will strongly reduce the variable cost of a unit produced. We can then consider company x (with low fixed costs and high variable costs) and company y (with high fixed costs and low variable costs) and compare their revenues for n units produced, assuming the selling price remains constant:

 

Revenue of company x for n units produced <= Revenue of company y for n units produced

n*(p-v_x)-F_x <= n*(p-v_y)-F_y

F_y-F_x <= n*(v_x-v_y)

(F_y-F_x)/(v_x-v_y) <= n

 

Since the left hand side is a quotient of positive quantities, it is positive. This tells us that past a certain number of units produced, the wealth generated by the operational cycle of company y will indeed be greater than that generated by company x. However, company y has a higher breakeven point. This means that it bears a higher operational risk than x, since it will need to sell more before it can post an operational profit.

 

As a conclusion, you can now realize that a high operational leverage (high fixed costs) can help you perform better than your competitors but also increases your operational risk and decreases your company’s flexibility: in case of an economic downturn, you will have to downsize production , won’t be able to cover the high fixed costs and will therefore post losses.