Operating profitability and working capital

How do you classify a company’s costs?

Operating costs can be sorted three ways, and each answers a different question. By behavior with output, a cost is fixed or variable. By nature, it is what the cost is. By function, it is what the cost is for. Operating costs are most of what a company spends, and they depend mainly on its business model and size.

Operating costsmost of what a company spends

• By behavior with output Memorize the one that drives operating leverage
  • Variable Memorize materials, merchandise, per-unit labor
  • Fixed Memorize salaried staff, depreciation, rent, software
• By nature Use it what the cost is
  • Employee pay, raw materials, office supplies
• By function Use it what the cost is for
  • Cost of sales, selling and marketing, general and administrative, R&D

The behavior split is the one that matters for risk. Variable costs rise and fall with output (materials, merchandise, per-unit labor). Fixed costs do not move with output within a normal range (salaried staff, depreciation, rent, software, insurance). Accounting groupings do not always match intuition: research and development is expensed as an operating cost though economically it is an investment, and interest is a financing cost, not an operating one.

Companies rarely disclose fixed and variable costs, so analysts estimate them. That is easier in industries that report unit costs and volumes, such as energy and airlines.

How do fixed costs create operating leverage?

Memorize

Operating profit is what the units earn after their own costs, less everything that does not change with units.

$$\text{Operating profit} = Q \times (P - VC) - FC$$

Here $Q$ is units sold, $P$ price per unit, $VC$ variable cost per unit and $FC$ total fixed operating costs. The part in brackets is the contribution margin : what each unit contributes toward fixed costs and profit.

$$\text{Contribution margin} = P - VC$$

For a firm to profit, the contribution margin must be positive and $Q$ high enough to cover $FC$. Break-even volume is $FC \div (P - VC)$.

The more of the cost base is fixed, the more profit swings when sales move. The degree of operating leverage (DOL) measures that sensitivity.

$$DOL = \frac{\%\Delta \text{operating profit}}{\%\Delta \text{sales}}$$

$$DOL = \frac{Q \times (P - VC)}{Q \times (P - VC) - FC}$$

More fixed costs means a higher DOL: profit rises faster in good years and falls faster in bad ones. A firm raises its leverage by swapping variable costs for fixed ones, for example by automating work that used to be paid per unit.

Exam tip Two-step questions are common. Find DOL from the numbers first, then multiply it by the sales change: 2.8 × −5% = −14%.

What do the margins show?

Three margins read down the income statement, each stopping at a different cost line, the last at earnings before interest and taxes (EBIT). Compare them over time and with peers, and ask which cost explains the change.

Revenueeach step down removes a cost group

• Minus cost of sales = gross profit Memorize gross margin; mostly variable costs
  • Minus operating expenses excl. D&A = EBITDA Memorize EBITDA margin; selling, G&A, R&D mostly fixed
    • Minus D&A = operating profit (EBIT) Memorize operating margin; before interest and tax

$$\text{Gross margin} = \frac{\text{revenue} - \text{cost of sales}}{\text{revenue}}$$

$$\text{EBITDA margin} = \frac{\text{EBITDA}}{\text{revenue}}, \quad \text{EBITDA} = \text{gross profit} - \text{operating expenses excluding D\&A}$$

$$\text{Operating margin} = \frac{\text{EBIT}}{\text{revenue}}, \quad \text{EBIT} = \text{EBITDA} - \text{D\&A}$$

Gross margin ignores everything below cost of sales. EBITDA margin adds selling, administrative and research costs but leaves out depreciation and amortization. Operating margin is after depreciation and amortization and before interest and tax.

How much cash does working capital absorb?

Memorize

Customers owe the company, stock sits in the warehouse, and suppliers are owed. The days measures turn each balance into how long it lasts, and the cash conversion cycle adds them up.

Working capitalcash tied up in day-to-day operations

• Days sales outstanding Memorize receivables ÷ revenue × 365
• Days of inventory on hand Memorize inventory ÷ cost of sales × 365
• Days payables outstanding Memorize payables ÷ cost of sales × 365
• Cash conversion cycle Memorize DSO + DIO − DPO
• Net working capital Use it receivables + inventory − payables, as % of sales

$$DSO = \frac{\text{receivables}}{\text{revenue}} \times 365$$

$$DIO = \frac{\text{inventory}}{\text{cost of sales}} \times 365$$

$$DPO = \frac{\text{payables}}{\text{cost of sales}} \times 365$$

Days sales outstanding is how long customers take to pay. Days of inventory on hand (also written DOH) is how long stock sits before it is sold. Days payables outstanding is how long the company takes to pay its suppliers.

$$CCC = DSO + DIO - DPO$$

The cash conversion cycle is the days between paying suppliers and collecting from customers. A short or negative cycle means suppliers finance the business. A lengthening cycle ties up cash and can signal slow collections or unsold stock.

Alongside the days, analysts track net working capital , receivables plus inventory minus payables, as a share of sales.

$$\frac{\text{receivables} + \text{inventory} - \text{payables}}{\text{revenue}}$$

Go deeper Why gross margin approximates contribution margin

Contribution margin per unit is price less variable cost per unit. If cost of sales is mostly variable and other operating costs are mostly fixed, then revenue minus cost of sales is close to total contribution, and gross margin is close to the contribution margin as a share of price. The approximation fails when cost of sales includes fixed items such as factory depreciation, or when selling costs include variable commissions. The notes to the financial statements show how costs are made up.

Go deeper Scale, scope and negative working capital

Economies of scale are falling costs per unit as output grows, usually because fixed costs are spread over more units (a variable-cost firm can also gain scale by bargaining harder with suppliers). Economies of scope are falling costs per unit as the number of product lines grows, because lines share costs. Both show up as improving margins as the company grows. Separately, some businesses run negative working capital: customers pay up front (subscriptions, ticketing) before suppliers are paid, so growth releases cash rather than absorbing it. That is a strength only if it comes from bargaining power rather than from stretching suppliers because the company cannot pay.