Don’t be alarmed by big profit falls

Happy Wednesday folks,

Today’s post is a little bit of a primer on operating leverage. Huh? What does that mean? You may see all of the profit reports flowing in this earnings season and be wondering things like: “How can a company stay in operation if their profits have fallen 97%?” Am I right? Well the answer is that “operating leverage” makes numbers look scary, when in fact they aren’t really so catastrophic. Let’s discuss this and then let me demonstrate by way of examples.

Businesses are faced with two types of general expenses: fixed costs and variable costs. Fixed costs are those that, in the short run, a business cannot change. These are costs like employee salaries, rent on their office buildings, interest on their debts, etc. In other words, irregardless of how many products the company sells they still have to pay these expenses. Variable costs are the opposite in that they fluctuate directly with production of goods and services. So if the company sells widgets their variable costs would be like: the costs to manufacture the widgets, the packaging costs, the shipping costs of the widgets, the marketing costs, etc. Is the distinction between these types of costs clear? I hope so.

The next concept that we need to understand is profit margin. Profit margin is the amount of money that a company earns from selling its good and services relative to its sales/revenues. So if a company sells $100 million worth of goods and earns $7.2 million then their profit margin is $7.2 million / $100 million = 7.2%. Well duh Jason, we all knew that. Yes, but when combined with an understanding of fixed and variable costs we can see why profit figures can fall very dramatically and very quickly. Let me demonstrate this by way of example.

Say the following is true about the JAV Corporation, a manufacturing firm…

Cost of goods sold (COGS) = 60% of revenues (this is a variable cost)
Sales, general & administrative (SG&A) = 15% of revenues (these are variable costs, too)
Research & development (R&D) = 5% of revenues (these are variable costs, too)
Depreciation & amortization (D & A) = $5 million (this is a fixed cost)
Interest expense = $12 million (this is a fixed cost)
Tax rate = 37.5% (this is a variable cost)

So given these numbers above, here is what the JAV Corp’s profit & loss/income statement would look like:

Line
(a) Revenues $100 million
(b) COGS $ 60 million (line b = line a x 60%)
(c) Gross profit $ 40 million (c = a – b)

Operating expenses:
(d) D & A $ 5 million
(e) SG&A $ 15 million (e = a x 15%)
(f) R&D $ 5 million (f = a x 5%)
(g) Total $ 20 million (g = d + e + f)
(h) Operating profit $ 20 million (h = c – g)

(i) Interest expense $ 12 million
(j) Profits before tax $ 8 million (j = h – i)
(k) Income taxes $ 3 million (k = j x 37.5%)
(l) Net profits $ 5 million (l = j – k)

OK, so that is a sample income statement for the JAV Corporation. What we can see is that the company earned profits of $5 million on revenues of $100 million. That means that their profit margin was $5 million / $100 million = 5% profit margin. Does this make sense? OK, but what happens if revenues fall by just 10%? This is a number that has been at least typical for many businesses in our current recession.

Line
(a) Revenues $ 90 million (a 10% decline from last year)
(b) COGS $ 54 million (line b = line a x 60%)
(c) Gross profit $ 36 million (c = a – b)

Operating expenses:
(d) D & A $ 5 million
(e) SG&A $ 13.5 million (e = a x 15%)
(f) R&D $ 4.5 million (f = a x 5%)
(g) Total $ 23 million (g = d + e + f)
(h) Operating profit $ 13 million (h = c – g)

(i) Interest expense $ 12 million
(j) Profits before tax $ 1 million (j = h – i)

(k) Income taxes $ 0.375 million (k = j x 37.5%)
(l) Net profits $ 0.625 million (l = j – k)

OK, so a mild 10% drop in revenues has resulted in a decline in profits of 87.5%!!!!! And that is what we mean by operating leverage. A 10% decline in revenues resulted in an 87.5% decline in profits. Wow! Why is there such a dramatic difference for the JAV Corporation, and actual real companies in our economy? The answer is a combination of fixed costs and low profit margin businesses. Low profit margin businesses cannot tolerate much of a drop in revenues because they need every dollar of those narrow profits in order to cover fixed costs. Does this make sense?

But here is the good news about this situation and why this topic is germane for evaluating businesses during this First Quarter earnings season: profits may be down dramatically, but to restore profitability will not require a huge increase in revenues. In the above example, our company will return to bigger profitability by simply restoring an 11.1% growth in its revenues (remember they have to grow $10 million more in revenues on a $90 million dollar base or 10 / 90 = 11.1%).

There is additional good news, too. Namely, the company can elect to cut back on its spending. It could temporarily cut: its marketing budget, its research & development efforts, or headcount. So when we see layoff announcements they may be scary, but what it means is that businesses are quickly adapting to a new operating environment. It also means that as revenues return they are likely to re-add jobs.

Thus, the ultimate point here is that a lot of the profit reports being announced this earnings season look grim, but in fact, the drama is in part due to operating leverage. The important number to focus on is really not profits, but the declines in revenue that businesses are experiencing. New sales are harder to earn than expenses are to cut. Does that make sense?

Have an excellent day y’all!

Jason

PS – I am sorry that the above pseudo-financial statements look so bad. Blame Blogger which does not have a friggin’ tab function in its posting software. Ugh!