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(^78) Financial Management
help you understand the topic. This understanding should make it simpler to make
appropriate choices or to understand what went into making the choices your firm has
already made.
Operating Leverage
While decisions about financial leverage is strictly the domain of the firm's highest
levels of management, operating leverage is an issue that directly affects the line
managers of the firm. The level of operating leverage a firm selects should not be made
without input from the managers directly involved in the production process. For example,
one of the most significant operating leverage issues is the choice of technology levels.
Selection of the highest level of technology available is not always in the best interests
of the business.
Suppose that we are opening a chain of copy centres. Each centre will provide a full
service operation. Customers can drop work off in the morning and pick it up later in
the day or the week. The employees will do the actual photocopying. We are faced
with the choice of renting a relatively slow copy machine, or the newest technology
machine, which is considerably faster. The faster machine is also considerably more
expensive to lease.
It will generally be the case that newer technology has a higher fixed cost and lower
variable cost than the older technology. Variable costs are those that vary directly with
volume. If we double the number of copies made, we double the amount of paper,
printing ink toner, and labour time needed for making the copies. One of the principle
functions of new technology is to reduce the variable costs of production.
It may turn out that a machine that can reduce the variable costs is more expensive to
make, and thus has a higher purchase or lease price than the older generation machine.
However, even if it doesn't cost more to make, its manufacturer will charge more for
the new machine than for the older machine. Intuitively, if the new machine is in some
respect better than the old machine (that is, it lowers the variable cost without reducing
quality), and doesn't cost more to buy, then no one will buy the older machine. Thus,
anytime we see two technologies being sold side by side, such as slow and fast copy
machines, we can expect the faster machine to have a higher rental fee or purchase
price, and therefore a higher fixed cost.
Let's assume that we could lease the slower, older technology copy machine for Rs
10,000 per year, or a faster, newer technology copy machine for Rs 15,000 per year.
Both produce photocopies of equal quality. Both use the same quantities of paper and
ink toner, but the faster machine requires less operating time. Therefore, the labour
cost is much lower for the faster machine. As a result, the variable cost of copies on
the slow machine is 30 paise each, while the variable cost of copies from the fast
machine is only 25 paise each. Is the faster machine the better bet?