Analyzing Operating Margins and Sales Levels

Analysts usually consider costs at a more aggregate level than the level used to analyze revenue and use a top-down, bottom-up, or hybrid approach when forecasting them. Variable costs are linked to revenue growth and may be modeled as a percentage of revenue or a projected product volume multiplied by product variable costs. However, fixed costs are not related to revenues but to investments in property, plant & equipment (PPE). They may be assumed to grow at their rate.

Analysts should determine whether the company benefits from economies of scale. Economies of scale occur when average costs per unit fall as volume rises. Factors that lead to economies of scale include:

• Greater bargaining power with suppliers.
• Lower cost of capital.
• Lower per-unit advertising expenses.

Gross and operating margins are positively correlated with sales levels in an industry that enjoys economies of scale.

Question

Which of the following is least likely a factor that leads to economies of scale?

1. Greater bargaining power with suppliers.
2. Lower cost of capital.
3. Fixed costs.

Solution

The correct answer is C.

Fixed cost is not a factor that leads to economies of scale. Fixed costs are expenses that are not directly related to revenue, for example, investments in property, plant & equipment (PPE).

A is incorrect. Greater bargaining power with suppliers is a factor that leads to economies of scale. A company with bargaining power with suppliers can negotiate better prices with the suppliers.

B is incorrect. Lower cost of capital is a factor that leads to economies of scale. Lower cost of capital enables a company to have cheaper access to funds, lowering their overall costs.

Reading 17: Financial Statement Modeling

LOS 17 (c) Evaluate whether economies of scale are present in an industry by analyzing operating margins and sales levels.