Page 113 of Level 1 2007 Secret Sauce mentions: “If sales are greater than the breakeven quantity, the firm with greater operating leverage will generate more profit” Do you agree with this sentence? Personally, I don’t. I reported an errata to Schweser and we exchanged a few emails but they haven’t issued an errata on their website regarding this sentence. I would like to have your opinion before explaining why I do think this is simply WRONG. Please comment. Marc
mhannebert The very idea of Operating Leverage is that the company gets more operating profits because of the presence of the leverage. And correspondingly, when sales drop, the losses will be magnified as well. So I believe the statement is correct, as stated. CP
Agree with cpk.
cpk123, this is exactly where I disagree. The sentence “If sales are greater than the breakeven quantity, the firm with greater operating leverage will generate more profit” means “the greater the DOL, the greater the profit”. I intend to proove that this is WRONG. Profit = EBIT EBIT = S - VC - FC with VC being variable costs and FC being the fixed costs We can also write EBIT = (S - VC) * (S - VC - FC) / (S - VC) We have DOL = (S - VC) / (S - VC - FC), the degree of operation leverage So, EBIT = (S - VC) / DOL So, assuming that (S - VC) is constant (which is reasonable for two firms within the same market), the greater the DOL, the lower the profit !!! Marc
To complement my answer… A correct sentence would be: “the greater the DOL, the greater the sensibility of profit to sales” or “If sales are greater than the breakeven quantity, THE EBIT OF the firm with greater operating leverage will BE more REACTIVE TO SALES”. That is the definition of the DOL… Schweser sentence is misleading because a reader could think that “DOL is a good thing !” (this is what cpk123 is thinking somehow) or “if I want to maximize my profit I need to have the greater DOL”. THIS IS NOT TRUE. It is not true because to increase the DOL you have to get the denominator S - VC - FC closer to zero (but still positive) which would mean, S and VC being determined by the market and the production method that you would have to increase the fixed costs. Have you already seen an industry where by increasing the fixed costs you increase the profit? Do you agree with my understanding? Regards, Marc
yes sensitivity to change in sales is higher for a company with the higher DOL. I am not trying to imply higher DOL is better. My statement immediately that followed said – when sales fall, the drop is greater. CP
Let’s take an example. Company 1: S = 1000 VC = 500 FC = 300 => DOL = (1000 - 500) / (1000 - 500 - 300) = 2.5 and EBIT = 200 Company 2: S = 1000 VC = 500 FC = 400 => DOL = (1000 - 500) / (1000 - 500 - 400) = 5 and EBIT = 100 Now, S changes to 1200 and VC to 600 Company 1: EBIT = S - VC - FC = 1200 - 600 - 300 = 300 Company 2: EBIT = S - VC - FC = 1200 - 600 - 400 = 200 So, Company 2, with GREATER DOL does NOT generate more profit. => Schweser is WRONG. Company 1’s EBIT moved from 200 to 300 Company 2’s EBIT moved from 100 to 200 So, what we can say is that, with GREATER DOL the EBIT reacts more rapidly to a change is sales (the relative variation is greater but NOT the absolute variation). Do you agree with me? Regards, Marc
Company 1: Before Operating Profit Margin: 200/1000 = 20% After Operating Profit Margin: 300/1200 = 25% Company 2: Before: 100/1000 = 10% After:200/1200 = 16% So Company 2 has a 60% increase in Operating Profits, while Company 1 has a 25% increase. So more profit is in the Operating Profit Margin sense. Also look at it relatively: 100/100 = 100% increase for Company 2 Company 1: 100/200 = 50% increase So because of the higher DOL - higher Profit (relative to what it was earlier) is an immediate response. CP
cpk123, I think you and me agree that “If sales are greater than the breakeven quantity, the firm with greater operating leverage will generate more profit” is wrong. I would somehow be happy with: “If sales are greater than the breakeven quantity, the firm with greater operating leverage will generate RELATIVELY more profit” but would prefer: “If sales are greater than the breakeven quantity, THE EBIT OF the firm with greater operating leverage will BE more REACTIVE TO SALES” The DOL is really the “sales elasticity of profit”. With regards to the “price elasticity of demand” you would not say “the greater the elasticity the greater the demand” but rather “the greater the elasticity the more the demand is reactive to price” So, same thing for DOL. Marc
I lightly skimmed your posts due to time sensitivity (I’m at work), but I think I agree with secret sauce. I think secret sauce is assuming all else equal, in which case by being above the break even point (both firms share the same break even), the firm with higher DOL should have greater profits due to the effects of the DOL multiplier. Specifying EBIT is not necessary as the IT part should have no impact in Operating Leverage. Interest will remain the same as what we’re referring to is DOL not DFL. Again, admittedly I lightly skimmed your posts, so I may be way off base, in which case, I apologize for wasting your time, and A/F’s megabites.
BS, If, the EBIT are the same, yes, it works (see example below). That is the cost structure is different: one company has more fixed costs and less variable costs. But if you are doing an assumption you have to mention it. Unless the assumption is obvious, which I don’t think is the case. It is more natural for me to think that the gross profit per unit is constant across the industry and then some company will have more fixed costs than others (R&D, advertissement etc.) So, this would mean that Schweser should modify the sentence in “ASSUMING TWO FIRMS HAVE THE SAME EBIT, if sales are greater than the breakeven quantity, the firm with greater operating leverage will generate more profit” Regards, Marc ------------------------------------------------------------------------------------------------- Example: Company 1: S = 1000 VC = 500 FC = 300 => DOL = (1000 - 500) / (1000 - 500 - 300) = 2.5 and EBIT = 200 Company 2: S = 1000 VC = 400 FC = 400 => DOL = (1000 - 400) / (1000 - 400 - 400) = 3 and EBIT = 200 Now, S changes to 1200 and VC to 600 / 480 Company 1: EBIT = S - VC - FC = 1200 - 600 - 300 = 300 Company 2: EBIT = S - VC - FC = 1200 - 480 - 400 = 320 So, Company 2, with greater DOL generates more profit.
BS, As you mention, if the firms have the same break even quantity it works as well because, again, the cost structure is necessary different. But here again the assumption should be clear: “ASSUMING TWO FIRMS HAVE THE SAME BREAK EVAN QUANTITY, if sales are greater than the breakeven quantity, the firm with greater operating leverage will generate more profit”. Marc
Yes, but my question is why are we heatedly debating a fairly obvious consideration in length? Does this minor nonstated assumption mean secret sauce is misleading as a resource? Not really. I guess I just don’t see what your trying to accomplish if we can all basically agree that given a pretty basic assumption it makes sense. Secret sauce is supposed to be an abreviated form of notes, if they had to state every assumption for every factoid, it wouldn’t be secret sauce anymore, it would be the monstrous set of CFAI books.
Black Swan, Please, don’t get me wrong, I’m NOT saying that the Secret Sauce is misleading as a resource. I think this is very helpful. I would call it as the summary of the summaries (the latter being Schweser Study Notes). I think the title of my threat is explicit enough. For my revisions of Level 1, I used the Secret Sauce extensively, trying to understand every sentence (and during that process, discovered a few “errors”) and adding some “important” information that were “missing” in my sense. Here, I’m just trying to highlight one point (even minor) that should be enhanced in the Secret Sauce. Period. Marc