Measuring Operating Risk
Why Talk About Risk?
So far, we focused on maximizing contribution margin.
But business also involves risk, and managers must be aware of:
- Operating Risk – arises from fixed costs
- Financial Risk – arises from borrowing (interest payments)
Key Definitions
1. Operating Leverage (DOL)
- Measures sensitivity of profit to sales volume changes
- Formula:
DOL = Contribution Margin / Profit Before Interest and Tax (PBIT)
High DOL = High fixed cost = High business risk
2. Financial Leverage (DFL)
- Measures sensitivity of profit before tax (PBT) to interest
- Formula:
DFL = PBIT / PBT
3. Total Leverage
- Overall business risk including both operating and financial risk
- Formula:
Total Leverage = DOL × DFL = Contribution / PBT
Case Study: Indian Hotels vs EI Hotels
| Hotel | Revenue (₹ Cr) | Variable Cost (₹ Cr) | Contribution (₹ Cr) | Fixed Cost (₹ Cr) | PBIT (₹ Cr) | Interest (₹ Cr) | PBT (₹ Cr) |
|---|---|---|---|---|---|---|---|
| Indian Hotels | 1800 | 1300 | 500 | 200 | 300 | 150 | 150 |
| EI Hotels | 1100 | 660 | 440 | 247 | 193 | 139 | 54 |
Leverage Metrics
| Metric | Indian Hotels | EI Hotels |
|---|---|---|
| DOL (Contribution ÷ PBIT) | 1.67 | 2.28 |
| DFL (PBIT ÷ PBT) | 2.00 | 3.57 |
| Total Leverage | 3.33 | 8.15 |
What If Revenue Drops by 10%?
- Variable cost drops 10%
- Fixed cost stays the same
- Apply DOL to estimate impact on PBIT:
| Hotel | Revenue Drop | Estimated PBIT Drop (%) |
|---|---|---|
| Indian Hotels | 10% | 16.67% |
| EI Hotels | 10% | 22.80% |
EI Hotels faces higher risk — more volatile profit due to higher leverage.
What If Revenue Rises by 10%?
- EI Hotels will enjoy larger increase in profit than Indian Hotels.
- High leverage magnifies both gains and losses.
Cost-Volume-Profit (CVP) Analysis
CVP: How Volume Affects Profit
This framework links Sales Volume, Cost, and Profit using:
- Contribution Margin
- Fixed Costs
- Leverage metrics
Assumptions of CVP Analysis
- Revenue, VC, Contribution are constant/unit
- Fixed costs remain constant within a relevant range
- Mixed costs are separable into FC & VC
- Sales = Production (no inventory changes)
- No capacity additions during the period
- Sales mix remains constant in multi-product firms
- No inflation
- No changes in productivity or technology
⚠️ These assumptions often don’t hold in the real world, but CVP still offers valuable insights.
Takeaway
- Understand the impact of fixed costs on profitability
- Use DOL & DFL to measure risk
- Use Total Leverage to plan for both downturns and growth
- Always be aware of the limitations of CVP in real-world settings