Issues_in_Accounting - Marketing Accounting Metrics...

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Marketing Accounting Metrics Tutorial Marketing Accounting Issues ©Backbone Press 2009 Marketing Accounting Issues Operating leverage Firms that have high total fixed costs relative to total variable costs have high operating leverage. Remember this definition, it is important. Companies that make planes, automobiles, computer chips and software have high total fixed costs compared to total variable costs. Companies with low total fixed costs relative to total variable costs have low operating leverage. Examples of such companies are home builders, wholesale distributors and labour intensive industries. The higher the operating leverage, the faster a firm’s profits will increase once sales exceed breakeven volume. These are the high growth stocks that speculators love. But the reverse is also so. The profits of high leveraged companies fall faster if they do not make breakeven. In other words, a high fixed cost structure is a potentially high return venture, but also a high risk of big losses venture as the following case-study explains. Between 1998 and 2001, more than a dozen national optical fiber networks were constructed and a similar duplication occurred in Europe. Upstart firms spent big and the major incumbents followed suit. At the same time a remarkable new innovation in feeding and extracting signals from such networks increased transmission capacity 100 fold. As a result total capacity for carrying telephone and internet messages increased over 500 times to meet demand that grew only four times over this period. 1 All the major telecom companies faced a disaster. Their fixed costs had increased enormously, far more than increased sales. The investment might have paid off if demand had also increased hugely as a result of the boom, but it did not. The losses were huge because of the high fixed cost structure the investments created. The big winners were the new start-up “card” companies that rented fiber network over-capacity very inexpensively on a variable cost basis – they paid a small variable cost for what they sold and used. Thus, the over- investment in capacity not only created huge operating leverage that worked against the incumbents but it also created a swarm of new low price competitors renting their networks off the incumbents at much lower cost. The result of the lack of thought about the risks of high leverage was a collapse in prices and several major bankruptcies. Banks who loaned money to telecoms lost hundreds of billions of dollars. Where were the business school graduates that understood operating leverage? Start-up firms often have low operating leverage. This is because they have very limited investment resources, so they have to outsource a lot of production, distribution and selling which are almost all variable costs to the entrepreneur. They cannot afford to invest in the fixed costs that would enable them to do it themselves. That means that when they grow, they do not get the increased profits from the fixed cost
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This note was uploaded on 04/11/2011 for the course MRKT 3023 taught by Professor Biritella during the Spring '11 term at FIU.

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Issues_in_Accounting - Marketing Accounting Metrics...

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