Operating Leverage and Inflation

Abstract

This article presents a generalization of the concept of operating leverage to include leverage factors/multipliers that can be used to estimate the earnings impact from any changes (including inflation-driven changes) in unit sales, prices, or costs. For a given firm, these price, cost, and sales multipliers may be synchronous or offsetting, resulting in a wide range of net leverage effects. In general, operating leverage increases as sales decline, so an adverse environment will find a firm confronted with greater leverage reactions—at just the wrong time. The resulting convexity effect can exacerbate the amplitude of any sales-driven earnings cycle. Incorporating specific inflation flow-through factors in the operating leverage/multiplier model allows the earnings impact of different forms of inflation to be more readily envisioned. This more granular approach often leads to surprising results. This article presents examples that illustrate how some forms of inflation can have a positive earnings impact, whereas other combinations can be quite devastating, especially in terms of real earnings.