Operating Leverage: The Benefit of Having Capacity to Create

June 25, 2015
The key to communicating the benefit of operating leverage is having a costing system that accurately characterizes the nature of cost as fixed and variable based on strong causal relationships.

It seems almost heretical to say, but fixed manufacturing capacity and capability (i.e. fixed costs) are the essence of a long-term competitive advantage for a manufacturer. Like all resources, fixed cost resources should be continuously evaluated, improved and optimized. But they should only be discarded after careful consideration of the competitive situations that could arise over the long term.

The degree of operating leverage is Fixed Costs divided by Operating Income (Sales – Fixed Cost – Variable Cost). When sales are not relevant, as in a component or support activity, the savings resulting from an initiative can be used. Operating leverage provides insight about the impact of cost structure on profitability.

The clearest examples of the benefits and risks of operating leverage arise in an outsourcing decision. Outsourcing may be for a product, component or a service such as maintenance.

Consider the breakeven diagram here. Insourcing results in losses for products or greater expense for services at low volume, but greater profits for products or greater savings for services at high volume. Outsourcing can improve profitability at low volumes; however, since you are paying someone else for their operating leverage, the curve is not as steep and profitability is lower or savings are less at higher volumes. An often overlooked consideration is the flexibility operating leverage provides to manage the nature of costs. Insourcing provides the options to reduce the fixed cost structure (the reduce FC option), reduce the variable costs (the reduce VC option), or reduce both through process improvement, innovation and investment. Unless you have tremendous leverage, outsourcing contracts typically don’t pass those savings along, and you are, therefore, limited in your responses to competitors’ actions.

When you think about it, this makes perfect sense. Expertise in manufacturing is expertise in using expensive resources efficiently and process improvement; retailers outsource production.

The key to communicating the benefit of operating leverage is having a costing system that accurately characterizes the nature of cost as fixed and variable based on strong causal relationships. This is not something you want to rely on your accountants for in most cases. They are normally trained to do product costing in accordance with generally accepted accounting principles (GAAP) with its pooled and generalized allocations, not using only cause-and-effect relationships.

Understanding operating leverage comprehensively requires that resource use and the associated fixed and variable costs be traced based on causal relationships at each step in the value chain—from a resource or group of similar resources to their direct output. This output will be consumed by another group of resources, which has another direct output. Eventually, this chain leads to final output or product with costs that have clear causal relationship to the producing resources and reflect the nature of the resource costs in the value chain. Costs with weak or no causal relationships to the product are not included in product cost because they distort decision-making information.

Generating this type of cost information is very different than the requirements of GAAP. Accountants try to create management information that links to GAAP; but since cause and effect is not a GAAP principle, the effort is doomed to fail. The only way to generate causal information on the nature of costs is to apply resource consumption accounting or a German management accounting method known as grenzplankostenrechnung (GPK for short). Activity-based costing has a tendency to make all costs appear variable and should be used with caution to ensure the fixed and variable nature of costs are accurately reflected.

>>Larry White, CMA, CFM, CPA, CGFM, [email protected], is executive director of the Resource Consumption Accounting Institute, which trains and advocates for improved cost information connecting operations to business performance.