Operating risk
Corporate finance
Dr hab. Joanna Błach
AWSB 2020/2021
Business risk (operating risk)
▪ the riskiness of the firm’s operations if it uses no debt
▪ it is the inherent or fundamental risk of a business
without regard to how it is financed
▪ it is the risk of reaching lower operating earnings (EBIT) than
previously expected
▪ main business risk factors are related to:
▪ lowered sales revenues
▪ eg. decrease in demand, in offered goods’ prices,
weak market position, ineffective promotion
▪ increased operating cots
▪ eg. increase of prices of materials and salaries,
additional operating expenses, operating costs’
structure considering fixed and variable costs
Fixed and variable operating
costs
▪ multiplied methods of producing a product or service may
exist, whereby firm spends more on fixed costs and less of
variable costs (or vice versa)
▪ variable cost – depend on the amount of production and sales
▪ e.g. costs of materials used, costs of energy
▪ fixed costs – invariable costs, the dimension is fixed and
unrelated to changes of the amount of production and sales
▪ e.g. depreciation, rent, managerial costs, local taxes
Factors of business risk
▪ demand (unit sales) variability
▪ the more stable demand for firm’s products (other things held
constant) the lower its the business risk
▪ sales price variability
▪ firms whose products are sold in highly volatile markets are exposed to
higher level of business risk
▪ input price variability
▪ if input prices are highly uncertain the exposition to business risk is
high
▪ the risk of increased operating costs
▪ the extent to which costs are fixed
▪ if a high percentage of a firm’s costs are fixed (andhence do n ot
decline when demand falls off) the firm’s business risk is increased
Main factor – type of
activity
business risk is strictly related to type of corporate activity
▪ type of activity determines:
▪ technology used
▪ assets structure, particularly fixed assets (and thus depreciation)
▪ type of activity influences on the structure of
▪ operating fixed costs and operating variable costs
▪ to ‘measure’ the business risk we use:
▪ BEP – break-even point analysis (accounting and cash)
▪ DOL – degree of operating leverage
Break-even point (BEP) -
meaning
▪ point in which sales revenues = total operating costs
▪ point in which total costs (both variable and fixed costs)
are equal to sales revenues
▪ point in which EBIT = 0
▪ there is no profits, but also no losses
▪ the point at which incremental net income turns from
negative to positive
▪ if sales revenues are higher that in BEP, the company’s EBIT
will be higher than 0, so it creates operating income (and
vice versa)
BEP graphical illustration
BEP calculation
▪Assumptions:
S=pxq C=F+qxv V= q x v
▪ S – sales revenues
▪ p – price of t he product per unit of output
▪ q – quantity of products (units of output)
▪ v – variable costs per unit of output
▪ C – total operating costs
▪ F – fixed costs
▪ V – variable costs (total amount)
Basic formulas
Contribution margin
▪ contribution margin means price minus
variable costs per unit = p - v
▪ the higher contribution margin in relation to
fixed costs F, the more products need to be
sold to cover total operating costs and gain
operating profit
▪ the higher F/(p-v), the higher BEP
▪ the higher BEP, the higher business risk
Degree of Operating
Leverage (DOL)
▪ relative mix of fixed and variable costs
required to produce a product or service
causes the sensibility of sales revenues
▪ DOL is an index number which measures
the effect of change in sales on operating
income (EBIT)
How to calculate
DOL?
Formula No 1
How to calculate DOL?
Formula No 2
this formula is derived from the previous one under the
assumption that:
Interpretation of DOL:
▪ an X percent change (increase or
decrease) in sales will produce DOL*X
percent change (increase or decrease) in
EBIT
▪ example:
▪ DOL = 2,4 (remember that DOL is not a
percentage)
▪ interpretation: a 1% increase in sales
will produce 2,4% increase in EBIT
▪ or: a 2% decrease in sales will produce14
4,8% decrease in EBIT
Interpretation of DOL
The effect of operating
leverage
▪ The above interpretation is based on effect
caused by the appearance of fixed costs
▪ DOL measures changes in EBIT caused
by changes in sales when there are
fixed costs in total operating costs
▪ the higher relation of fixed costs to
variable costs and sales, the more
powerful effect of operating leverage
and the higher degree of operating
leverage
Interpretation of DOL
The relationship between DOL
and sales
▪ DOL gives the information of the percentage
change in operating income (EBIT) associated
with a given percentage change in sales
▪ high DOL (other things held constant) means that a
relatively small change in sales will result in a large
change in operating income
▪ higher DOL (other things held constant) means greater
degree of business risk measured by variability of EBIT
▪ DOL is calculated for defined level of sales
▪ for different levels of sales, DOL will be different
▪ the higher level of sales, the lower DOL, which
means
▪ decrease of fixed costs in relation to the level of sales
▪ decrease in business risk
Interpretation of DOL
The relationship between DOL
and BEP
▪ firms operating at close to its BEP level
will have high degree of DOL
▪ when sales is close to sales in BEP, DOL
will be going to infinity (∞)
▪ the higher is DOL, the higher is the risk of
sale below BEP
Thank you!