Category MBA

Operating leverage

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Operating leverage is the relationship between sales and revenue (Price*Quantity of units sold) and operating profit (which is also called EBIT (earnings before interest and taxes)). It is a measure of how the potential use of fixed costs can enlarge the effect that change in sales volume has on operating profit (EBIT).

We can represent the calculation of operating leverage as follows:

Sales (P * Q)

Less: Fixed operating costs (FC)

Less: Variable operating costs (VC*Q)

= EBIT

Or

EBIT = (P*Q)-FC-(VC*Q)

This simplifies into:

EBIT = Q * (P-VC) – FC

When do firms have operating leverage?

If a firm has fixed costs, it has operating leverage. Because fixed cost (FC) is unchanged, an increase in sales revenue (P*Q) results in a proportionally bigger increase in EBIT (earnings before interest and taxes, which is also called operating profit). However, decrease in sales revenue (P*Q) will result in a proportionally bigger decrease in EBIT.

Increase in operating leverage increases business risk, which is a chance that the business will not be able to cover its operating costs.

How to calculate the degree of operating leverage (DOL) of the firm?

To calculate degree of operating leverage, which is just a way to measure operating leverage of the firm, we can use the following formula:

DOL =% change in EBIT/% change in sales

Therefore, if the degree of operating leverage is greater than 1, than operating leverage exists (which is the case as long as the company has fixed operating costs).

Businesses can increase their operating leverage by substituting variable costs for fixed costs, where possible. For example, salaries to sales personnel could be fixed instead of variable of units sold. Of course, many other variables need to be taken into account to make such a decision, such as consideration of how such changes would affect motivation levels of sales personnel.

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Leverage

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In finance, leverage (which is also called gearing or levering) refers to the use of debt rather than equity as a source of capital to finance investments and reinvestments. The more debt the business uses the more leverage it has.

As leverage increases, the risks also increase and so does the return on investment. However, as leverage decreases, the risks also decrease as well as the return on investment. Management have almost total control over the risk introduced by increased leverage.

There are three types of leverage:

  • Operating leverage – refers to the relationship between sales revenue and operating profit (which is also called EBIT (earnings before interest and taxes))
  • Financial leverage – refers to the relationship between operating profit and EPS (earnings per share)
  • Combined or total leverage – refers to the relationship between sales revenue and EPS

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Financial Position Statement Format (Balance Sheet)

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As we mentioned earlier, a balance sheet (financial position statement) is one of the most important financial statements. Other important financial statements include the income statement, cash flow statement and statement of changes in equity. A balance sheet (financial position statement) outlines the financial position of the company at a given point in time. It is often called a “snapshot” of the company’s financial position.

Below we present the general format of the balance sheet (financial position statement). We also explain the items in the balance sheet.

General balance sheet format

(1) ASSETS

(1.1) Current assets comprise:

Cash

+

Marketable securities

+

Accounts receivable

+

Inventories

=

Total current assets

(1.2) Non-current assets (fixed assets) comprise

Land and buildings

+

Machinery and equipment

+

Vehicles

+

Fixtures and Furniture

+

Other (for example financial leases)

=

Total gross fixed assets

Less: Accumulated depreciation

=

Net fixed assets

+

Other assets (investments, goodwill, copyrights and patents)

=

TOTAL ASSETS

(2) LIABILITIES AND (3) EQUITY

Liabilities comprise current and non-current liabilities:

(2.1) Current liabilities:

Accrued expenses

+

Accounts payable

+

Short-term notes (notes payable)

=

Total current liabilities

(2.2) Non-current liabilities

Mortgage

+

Other long-term debt

=

Total Non-current liabilities

(3) Equity comprises:

Common stock

+

Paid-in capital in excess of par on common stock

+

Preferred stock

+

Retained earnings

=

TOTAL EQUITY

=

TOTAL LIABILITIES AND EQUITY

Assets

CURRENT ASSETS

Current assets are listed first in the balance sheet (financial position statement). Current assets are those that can be converted into cash within 12 months. The main reason why small businesses often experience financial trouble is inefficient management of current assets. That is, they run out of cash. This can happen for such reasons as having insufficient cash on hand or underestimating the amount of time it takes to liquidate assets to create cash.

Marketable securities, also often called “near cash”, are liquid securities such as US Treasury bills.

Accounts payable refer to money that has not yet been received from the firm’s debtors. Debtors are the firm’s customers who bought from the firm on credit and still need to pay for a product or service provided.

Inventories refer to the raw materials, products in the process of production and completed products ready for sale. Basically, inventory is the physical products the business intends to sell.

In the balance sheet (financial position statement), the most liquid assets are usually listed before less liquid assets. That is why we also listed current assets in terms of decreasing liquidity: cash, marketable securities, accounts receivable and inventories.

NON-CURRENT ASSETS OR FIXED ASSETS

After current assets are listed, we can list non-current assets in the balance sheet. Non-current assets or fixed assets refer to assets that cannot be converted into cash within a 12 months period. The majority of fixed assets are depreciable. It means that the cost of the asset is allocated over its useful life and deducted as expenses on the income statement. This decreases the amount of tax the firm has to pay.

On the balance sheet we need to show the net fixed assets, which refer to the gross fixed assets (assets before depreciation is taken into account) less accumulated depreciation (depreciation deducted over the useful life of the asset, up to this point). The net fixed assets of the firm is also referred to as the book value.

OTHER ASSETS

Other assets show assets on the balance sheet that do not fit under the first two categories and include such assets as goodwill, copyrights and patents. For some companies this can contribute a sizable portion, if not the majority, of their value.

Liabilities and equity

The second part of the balance sheet presents how the business was financed. It basically shows from which sources assets were financed. The two main sources of financing are debt and equity.

CURRENT LIABILITIES

We start the second part of the balance sheet with current liabilities. Current liabilities include accrued expenses, accounts payable and short-term notes.

Accrued expenses are expenses which the company is obligated to pay within 12 months and includes such items as salaries and wages.

Accounts payable refer to payments that company is still obligated to make within 12 months to the creditors which supplied their product on credit to the company.

Short-term notes refer to the money that must be repaid to the lenders within 12 months.

LONG-TERM LIABILITIES

The next step in compiling the balance sheet requires us to list long-term liabilities. Long-term liabilities refer to debt payment which is due in a period longer than 12 months.

EQUITY

The last step in compiling the balance sheet requires us to illustrate the equity position of the firm. Equity indicates the claims of firm’s owners on the firm.

Items “common stock” and “paid-in capital in excess of par on common stock” indicate the amount paid by common stock shareholders for their shares of common stock.

Preferred stock shows the amount of money received from issuing preferred stock.

Retained earning show the earnings of the firm which were not distributed in the form of dividends to the shareholders.

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Overview of the Balance Sheet (Financial Position Statement)

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A balance sheet – financial position statement is one of the most important financial statements. Other important financial statements include the income statement, cash flow statement and statement of changes in equity.

A balance sheet is the financial position of the company at a given point in time. It is often called a “snapshot” of the company’s financial position.

How to think about a balance sheet (financial position statement)

A good way to compare the balance sheet statement, income statement and cash-flow statement is to think of a river leading to a dam. The income statement and a cash-flow statement record the movement of money over a specific period of time. It is similar to recording the volume flowing down a river over a specific period. The balance sheet – financial position statement is the dam. Everything collects there.

Therefore, by looking at the balance sheet we can see how everything comes together at a given point in time. If the company is reporting strong cash-flow in the statement of cash-flows, then that cash must be collecting somewhere, in the balance sheet. Provided a balance sheet is constructed honestly and correctly, it is a wonderful source of information about the company. Like a dam, any poisonous material or waste, gets washed down into the balance sheet. Therefore, paying careful attention to the balance sheet (financial position statement) allows to evaluate important information about the company.

Understanding the balance sheet (financial position statement)

To understand the balance sheet (financial position statement), one first needs to understand the difference between assets and liabilities. A simple explanation is as follows: if you take an unpaid vacation or are between jobs for a while, assets will or will have the potential of adding money to your bank account every month. Liabilities, however, will deduct money from your bank.

For example, if you own a fully paid-off house, which is currently empty, this is an asset. You may choose to earn money from this asset by renting it out. Therefore, even if you are not working, you will have rental income generated from your asset. However, if you leased an expensive car and lost your job, the bank will still deduct money from your bank account every month. Therefore, this is a liability. Alternatively, if the car is fully paid-off, it is an asset and you could generate income from it.

We also can define assets and liabilities more formally.

ASSETS

Assets are any tangible or intangible economic resources that a company or individual possesses and which can be used to cover the individual’s or company’s debt. For example, in the case of an individual, retirement savings and stocks are examples of assets. In the case of a company, fully owned equipment and buildings are examples of assets.

As represented on the balance sheet, current assets are assets which are excepted to be converted into cash within 12 months and non-current assets are assets which are expected to be converted into cash at some point in the future which is longer than 12 months.

LIABILITIES

Liability is a legal obligation to settle debt which arises as a result of a past transaction or event. A liability should, by law, be settled at a specified future period or over a specified period and, possibly, at specified intervals.

As represented on the balance sheet, current liabilities are debts which must be settled within 12 months and non-current liabilities are debts which must be settled at some point in the future which is longer than 12 months.

An example of personal liability can be a personal loan that must be repaid to the bank. Company liability examples include accrued expenses such as wages as well as long-term loans.

 

Innovation and Small Business

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Why do innovation and small business go together? Consider this: small businesses account for 95% of all radical innovations and for half of all innovations. Inventions such as the personal computer originated from a small business. Therefore, innovation and small business are often very much aligned and this trend is expected to continue into the future.

After all, innovation and small business have to be associated because, in many cases, one can only break into established markets and compete with the recognized giants by introducing innovative solutions to customers’ needs.

Interestingly, large organizations usually focus on improving existing solutions rather than on inventing new solutions. As Scott Anthony, co-author of the book “Seeing What’s Next: Using Theories of Innovation to Predict Industry Change”, and partner at Innosight, a Watertown (Massachusetts) Innovation consulting firm, mentioned, “The thing that’s so tricky is that everything an established company is trained to do – watch your markets carefully, listen to your best customers, innovate to meet their needs – oftentimes causes them to miss some of these disruptive transformation trends”. Moreover, large organizations are often very bureaucratic, which slows down or even kills innovation efforts of employees.

The factors above further contribute to the competitive power of innovation in small business. Small business should embrace its less bureaucratic environments and enhance its innovation efforts. However, innovation efforts of small business have to be designed carefully. The following factors should be considered within the context of innovation and small business:

Six factors to consider

1 – Entrepreneurs need to ensure that adequate financing is available or is accessible for the entire duration of the innovation effort.

2 – A new and innovative product or service must add real value to customer. Innovation can only be a successful effort if there is a demand for the new solution.

3 – It is best to choose an area in which an entrepreneur has personal experience.

4 – It is best to concentrate on products and services which are currently not available or underserved. This will allow entrepreneurs to achieve more rapid growth as well as to have less competition, at least initially.

5 – If innovative products and services is the focus of the business, than continuous innovation should be given a priority.

6 – It is advisable for innovation to be of a type that allows for further products and services to be developed based on the initial innovation.

Innovation and small business success

Due to widespread globalization and advancement in technologies, innovation is accessible to small businesses in a way that was never possible before. Innovation and small business should go together, it is the only way to establish a strong foothold in the market while competing with recognized giants.

There has never been a better time for small businesses to grow and prosper. Think about the opportunities that technology and globalization offers to small business. For example, the internet has made it possible to access markets anywhere in the world, at a very low cost. The only thing that small businesses need is a solution to customers’ needs that is new and in demand. Small business needs innovation. Therefore, innovation and small business success are also very much aligned.

The following article may be of interest to you if you would like to understand this better: “All Shook Up – You can’t control disruptive innovations, but you can learn to predict them–and to react to them in a positive way.”

 

Entrepreneur Mindset

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Entrepreneurship and development go together. Learning to think like an entrepreneur, whether you run your own business or work for an organization, is a critical skill to be successful in business.

Entrepreneurs need to have a mix of skills at hand: knowledge of marketing, leadership, basic finance, operations, talent management, business management, technology and other skills. They need to have these skills since initially their companies usually consist of 1 or 2 employees and they do not have the luxury of having specialists.

Learning enough of these skills will give you an advantage. You do not need to be an expert in all of these areas. You just need to have a basic knowledge and be able to see an opportunity from all angles so you can have an overall picture. An entrepreneur’s mindset is a great advantage in business. Thinking like an entrepreneur forces you to look for opportunities which otherwise can be overlooked.

If you surveyed employers today, the vast majority would say they wish their employees were more entrepreneurial. This has been something employers have sought for the last 20 years and it will continue to be highly sought after.

There is another more compelling reason to think like an entrepreneur. No matter how happy you may be in your career today, there will likely come a time when you will want to make a change. This could be due to having a terrible manager, poor working conditions, a faltering company or you may just have outgrown your job. Either way, you need to have options. Thinking like an entrepreneur and having the skills of one, allows you to see opportunities and to exploit them.

Reasons to act like an entrepreneur

1 – One of the reasons is because you need to keep your options open to someday run your own business.

On average, you will never be as wealthy as you could be by working for someone else.

Moreover, you never will be “FREE” and, at some point in your career, being “FREE” may become a requirement for you rather than a preference. This happens very often with successful employees of corporations of all sizes and types. Consequently, many of them leave to start their own businesses to satisfy their need for freedom, personal satisfaction, the feeling of building something of their own and the opportunity to spend more time with family, amongst others.

2 – You need to learn to think like an owner and entrepreneur. If you adapt your attitude and acquire a feeling of accountability that comes with being an owner – you will stand out amongst peers and have a greater chance for accelerated career development.

3 – Learning to think like an entrepreneur helps you to see the big picture and this is crucial for your career development. The higher you move up along your business career ladder, the more conceptual skills you will need and the less technical skills you will need. Conceptual skills refer to the ability to think strategically and see the big picture.

Entrepreneurship, DEVELOPMENT and Innovation

It can also be argued that entrepreneurship and development of the economy as a whole go together. The distinguished Harvard economist Joseph Schumpeter argued that capitalism exists in the state of “creative destruction”, where innovation leads to new companies replacing old ones. Entrepreneurship leads to development. He viewed entrepreneurship as a catalyst for growth of the economy. He argued that it is entrepreneurs who are the driver for the sustainable long-term growth of the economy. Therefore, he argued that entrepreneurship and development of the economy are inseparable.

***

Most employees know their job well, but they are weak at understanding the overall business. Acquiring the mindset of an entrepreneur will allow you to see the big picture. You can set yourself apart.

 

The economic policy and special interest groups

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Yet another sub-group that influences the economic policy decision-making process is special interest groups. Individuals with similar interests form a special interest group which makes them more powerful in influencing the decision-making on economic policy and other issues. The beneficial factors of special interest groups within context of economic policy decision making is supported by pluralism, which is a model of economic policy making.

Special interest groups that exert an influence on economic policy decision-making include three main sub-groups:

  • organized business groups
  • non-governmental organizations
  • organized labor groups

Examples of organized business groups include organized business and agriculture. Examples of non-governmental groups include educational and welfare organizations. Examples of organized labor groups include trade unions.

Other interest groups that exert an influence on economic policy decision-making include international financial organizations such as the World Bank and the International Monetary Fund (IMF) as well as media and foreign governments.

Some individuals hold the opinion that special interest groups are excessive in their quantity and pressure on the government to influence decisions concerning economic policy. They feel that such pressure and “disproportionate” influence only complicates and slows down the decision-making process with regards to the economic policy.

Nevertheless, each special interest group is an important constituent influencing government with regards to economic policy decision-making process. According to pluralism, one of the models of economic policy making, the role of each interest group is crucial along with roles of a technocrat, a political leader and a bureaucrat.

On the flip side of the coin, special interest groups are also seen to have a beneficial influence within context of economic policy decision making. They serve as a watchdog of the government’s actions (e.g. actions of politicians, technocrats and bureaucrats) and of building important networks within communities or regions.

 

A bureaucrat and bureaucrat’s role in setting the economic policy

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A bureaucrat is a constituent of a bureaucracy. Bureaucracy is usually means governments but can also refer to specific organizations. As an example, a large private organization is also a bureaucracy and an individual working for such an entity is a bureaucrat.

Bureaucrat, as a word, originated from the French word bureau, which means “desk”. This name was selected because bureaucrats are seen as individuals who work behind the desk.

However, here we are concerned with a bureaucrat who is an employee of the government and an economic policy decision-making participant.

A bureaucrat is an agent of a political leader (principal) and he or she implements policy choices of politicians. One of the big differences between a politician and a bureaucrat is that the latter is appointed and the former is elected. Some bureaucrats are technocrats. Technocrats are professionals, such as economists and engineers, who advise politicians on the areas of their expertise. For example, economists may advise on economic policy choices.

Bureaucrats are often driven by motives other than being a faithful servant (agent) of politicians (principals). A bureaucrat is a human being with his or her own agendas, desires and ambitions. Along with meritorious motives, he or she may be driven to maximize income, status and power or to advance his or her career.

In the economic theory, it is assumed that a bureaucrat is driven to maximize his or her budget. This occurs because the bigger the budget that a bureaucrat controls, the bigger the perceived power and the status and, thus, satisfaction of a bureaucrat.

Therefore, bureaucrats have an incentive to arrange for a budget which is above the optimal (most effective) budget level and this leads to excessive spending by government. In the pursuit of enlarging the budget, a bureaucrat may exaggerate benefits and downplay costs and threats.

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A political leader and his role in setting the economic policy

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The word Politician, a political leader, originated from the Greek word “Polis”. A politician is an individual who affects public decisions, such as decisions on the economic policy. A politician is either an individual who already serves in a government or which seeks to be elected to serve their nation or community.

The role of a politician in setting the economic policy is very prominent. According to standard economic theory, technocrats (e.g. economists) provide recommendations on the economic policy choices to a political leader who, in turn, make economic policy choices which are implemented by a bureaucrat.

Therefore, a politican is actually involved in making the economic policy choices. This is different from bureaucrats who implement the policy choices of politicians.

A politician, as a role player in the government, earns some resentment from the general public due to the perception that politicians are driven by desire to maximize votes for their next election rather than by serving the interests of the public. This is, of course, true in some cases and not in others.

Political business cycle theories (models)

A politician is a human being and has feelings, dreams, goals, desires and agendas, like any other person from any walk of life. Therefore, it is only natural that a politician may be driven by a personal agenda. This must always be kept in mind. Especially since standard economic theory assumes that a political leader is driven by the goal of enhancing the well-being of a nation rather than by desire of personal gains.

Some economic theories, however, attempt to explain a politician’s actions as guided by attempt to maximize votes. Such theories are called political business cycle theories. Political business cycle theories are further subdivided into the partisan model and opportunistic model.

PARTISAN MODEL

Based on a politician being a “partisan” of the party that he or she belongs to. Each party has different priorities and those priorities will significantly influence the economic policy decisions.

OPPORTUNISTIC MODEL

This theory was first proposed by Nordhaus. Nordhaus suggests that his proposed theory rests on 3 assumptions:

1 – The main goal of a politician is to stay in the office

2 – The current performance of the economy will affect election

3 – A politician has strong incentives to make economic policy decisions which will lead to expansionary monetary and fiscal policy to expand performance of the economy in the short run. This will be followed by contractionary monetary and fiscal policies to combat inflation (which occurred due to expansionary policies).

The criticism of the opportunistic model arises because it is unlikely that a political leader will be able to effectively manipulate economic performance in the short-term.

Empirical evidence does not explicitly and completely support models of the political business cycle.

 

The economic policy decisions: who is behind them?

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We mentioned in the introduction to the economic policy that economic policy is a purposeful action (or purposeful non-action) by the government with the intent to affect economic behavior with the goal of achieving certain outcomes which will improve the material well-being of society. However, of what does government consists? Who really makes the decisions on economic policy?

It is generally accepted in the conventional economic theory that economists (technocrats) advice politicians with regard to the economic policy choices. Politicians than make economic policy choices which are implemented by public workers (bureaucrats).

Each of these sub-groups of the government have their own motivation behind making certain policy decisions and their motives must be recognized. A political leader (policy maker), for example, is generally motivated to increase his or her votes and to stay in the power. A bureaucrat is usually motivated to increase his or her budget which will increase his or her power.

Government sub-groups consist of real people with their own agendas, motives and goals, which are sometimes not aligned with the assumption the government always acts in the national interest with the goal of achieving economic stability and prosperity. This will distort the effectiveness and appropriateness of the economic policy choices.

Now let’s take a look at some sub-groups of the government which are involved in economic policy decision making.

In the articles that follow we will take a closer look at different groups which influence economic policy decisions. We will particularly discuss a political leader’s role and political business cycle theories. We will also take a closer look at the role of a bureaucrat, including the role of a technocrat, and their role in the economic policy decision making. Lastly we will address the role of the special interest groups within the context of their influence on the economic policy decision making.

Later, when we will discuss four models of economic policy making, we will look at the role of each constituent within each model in more aggregated format. However, we will start from looking at their roles in isolation:

The role of a political leader in setting economic policy is very prominent. According to standard economic theory, technocrats (economists) provide recommendations on economic policy choices to a political leader or group of politicians who, in turn, make economic policy choices which are implemented by bureaucrats.

The role of a bureaucrat in setting economic policy is instrumental. A bureaucrat is an individual who essentially implements economic policy set by politicians.

Special interest groups that exert an influence on economic policy decision-making include three main sub-groups: organized business groups, non-governmental organizations and organized labor groups.

***

You may read this related article entitled “Who is behind Bush economic policy” for deeper understanding of how economic policy decisions are made in the real world.

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