Analytical redefinition of DOL and managerial investment decisions
Abstract
Purpose
The purpose of this paper is to develop alternative analytical measures for the degree of operating leverage (DOL) that reflect the impact of uncertain demand shocks in the product's market on optimal production levels, sales and profits of the firm.
Design/methodology/approach
The elasticity measures are constructed according to a theoretical formulation of optimal production level that corresponds to demand shocks for given predetermined levels of fixed cost.
Findings
The paper suggests two main findings. First, the analytical marginal DOL is at least twice the traditional DOL depending on the structure of the shock, the production function and demand's elasticity. The traditional DOL is equal to the measure only when large-scale negative demand prompts the firm to abandon production. Second, the paper also provides an analytical measure of DOL in terms of elasticity of profit to sales rather than to production level. Both theoretically and empirically elasticity of profit to sales can be better measured and better reflects risk.
Research limitations/implications
This paper should be extended to encompass multiple shocks on demand and supply while investigating the empirical multi variants distribution of the shocks.
Practical implications
The model can be used by managers who are well informed about the fixed and variable costs of their firm. The model determines the mean profit- risk trade off which is an important factor in all investment decision problems.
Originality/value
Surprisingly and according to the best knowledge, this paper is the first attempt in the literature for alternative analytical DOLs’ formulations that is coherent with basic economic theories of optimal production level under risk.
Keywords
Acknowledgements
JEL Classifications — D24, G39
The authors would like to thank Ono Research Institute in Finance (ORIF) for the financial support, and the participants of the 2013, Second Ono Academic College Business Research Conference and an anonymous referee whose comments improved the paper considerably. All errors are under the authors’ responsibility.
Citation
Kroll, Y. and Yechiam Aharon, D. (2014), "Analytical redefinition of DOL and managerial investment decisions", Managerial Finance, Vol. 40 No. 7, pp. 734-754. https://doi.org/10.1108/MF-08-2013-0218
Publisher
:Emerald Group Publishing Limited
Copyright © 2014, Emerald Group Publishing Limited