Operating Leverage in Cost Reduction Capital Budgeting Proposals: A Rigorous and Practical Approach

Abstract

This paper presents a method for integrating the operating leverage concept into cost reduction capital budgeting decisions. The method is rigorous, since it is derived from a market-risk, asset-pricing theory. At the same time, the model is practical, since the risk measure "drops out" of the derivation and therefore does not need to be defined or measured for application. I. INTRODUCTIONThe purpose of this paper is to show a simple way to incorporate operating leverage into capital budgeting proposals that will reduce operating costs. Despite the fact that many well-regarded textbooks introduce the topic of operating leverage, these texts do not demonstrate how to integrate this concept into capital budgeting proposals for costreducing technological changes. Presumably, students are expected to perform this application on their own when they become practitioners.At first glance, it might seem that the task would involve measuring the "new1' operating leverage assuming the proposal is adopted, relating this measure t o some specification of risk, and relating t h s risk to the cost of capital. While the idea of this approach is readily grasped, practitioners might not implement the approach, because of the difficulties in choosing and estimating the "appropriate" measure of risk. Moreover, the attempts of practitioners at implementation will probably involve some ad hoc procedures, especially if the proper steps are not spelled out in texts. The methodology offered in this paper circumvents these problems.In fact, the methodology suggested in this paper offers the best of two worlds. First, the application of the technique involves no specification of risk and thus is very easy to