Extending the Profit Elasticity Measure of Operating Leverage in Managerial Economics Texts

By Hodgin, Robert; Kiymaz, Halil | Journal of Economics and Economic Education Research, September 2005 | Go to article overview

Extending the Profit Elasticity Measure of Operating Leverage in Managerial Economics Texts


Hodgin, Robert, Kiymaz, Halil, Journal of Economics and Economic Education Research


ABSTRACT

The authors suggest recasting operating leverage (DOL) treatments in managerial textbooks. They extend the profit elasticity form of DOL used by firms to other than competitive markets by introducing nonlinear cost and revenue functions. From their results, the authors urge text writers to highlight four key issues: the role and limitations of 1) management--long run versus short run operating leverage decisions, 2) engineering--variable cost changes associated with fixed cost changes, 3) economic forces--competitive versus non-competitive markets and 4) mathematical results--DOL equals zero at the maximum profit output level, regardless of the level of fixed cost.

INTRODUCTION

Operating leverage is important to firm management for one reason, additions to operating fixed costs affect a firm's value by increasing risk as measured by the variability of returns (Lev, 1974, and Berner, 2002). Operating leverage discussions often follow as a natural extension to linear breakeven analysis in managerial economics textbooks. Application of the generally received profit sensitivity formula, the degree of operating leverage (DOL), is limited both theoretically and practically.

Most textual treatments ignore the role DOL variables other than fixed costs play. Most authors assume overly restrictive linear cost and revenue functions, while subsequent chapters develop standard non-linear economic cost and revenue functions.

The roles of management, engineering and economic markets along with the measure's inherent mathematical limitations are left unstated. This article reviews unstated aspects of the DOL measure and offers a more theoretically complete framework for operating leverage textual discussions aimed at the practicing corporate managerial specialist.

Aspects of DOL we consider important include a) consistency with orthodox economic theory, b) recognizing the larger business risk context within which the DOL measure is applied, c) a clearer view of management's role in influencing certain DOL parameters as business risk components and d) some important analytical limitations inherent to the measure's form.

Business risk is a central determinant of a firm's value, the risk-adjusted present value of future profit. Several important parameters affect a firm's business risk position. Among them are price, variable costs, operating fixed costs, the output rate and the stability of demand. The DOL measure contains variables that capture four of these parameters. The fifth, demand stability, is a through-time assessment while DOL is a point in time measure. The level of operating fixed cost, the parameter of greatest attention in textual DOL discussions, is only one business risk parameter. A change in a single business risk parameter in the DOL expression also affects the remaining parameters. For example, increases in operating fixed cost without a compensating reduction in unit variable cost may require increases in output to sustain a desired profit level. A meaningful discussion of DOL should at least mention the distinction between management-led choices addressing the firm's business risk posture versus market forces and engineering-based limits. Finally, other than for expository simplicity, we question the use of restrictive linear cost functions in the DOL formula application, when textual narrative in the same text stresses non-linear relationships.

Discussion in Section 2 confirms the mathematical equivalence between various DOL measures and presents works by Dran (1991), Long (1992) and shows that DOL is sensitive not only to changes in the firm's operating fixed cost but also to short run output. That section suggests that narrative treatments indicating which DOL parameters management can directly influence would help place the measure into a useful operational context. Section 3 extends the DOL expression to include a cubic variable (and total) cost function and parabolic total revenue function to demonstrate that DOL equals zero at the theoretically optimized output, regardless of the level of fixed cost. …

The rest of this article is only available to active members of Questia

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA 8, MLA 7, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

(Einhorn 25)

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Note: primary sources have slightly different requirements for citation. Please see these guidelines for more information.

Cited article

Extending the Profit Elasticity Measure of Operating Leverage in Managerial Economics Texts
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Help
Full screen
Items saved from this article
  • Highlights & Notes
  • Citations
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

matching results for page

    Questia reader help

    How to highlight and cite specific passages

    1. Click or tap the first word you want to select.
    2. Click or tap the last word you want to select, and you’ll see everything in between get selected.
    3. You’ll then get a menu of options like creating a highlight or a citation from that passage of text.

    OK, got it!

    Cited passage

    Style
    Citations are available only to our active members.
    Buy instant access to cite pages or passages in MLA 8, MLA 7, APA and Chicago citation styles.

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

    1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

    Cited passage

    Thanks for trying Questia!

    Please continue trying out our research tools, but please note, full functionality is available only to our active members.

    Your work will be lost once you leave this Web page.

    Buy instant access to save your work.

    Already a member? Log in now.

    Search by... Author
    Show... All Results Primary Sources Peer-reviewed

    Oops!

    An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.