4.14 Analyzing Capacity Activity and Productivity

First we need to convert the gross margin form of the income statement to a variable costing for both Wal-Mart and Target.

Note: Valuation Tutor requires you to specify the percentage of the total that is allocated to variable costs, with fixed costs making up the remainder.  For a retailer we expect the majority of COGS to be a variable cost because they are turning over inventory at a quick rate as revealed in the working capital analysis.  So we will assume the allocation is 100% variable for COGS.  For SG&A we will assume a traditional 30% variable.   and for other costs these are generally fixed so we will assume 5% variable for other.

Armed with these assumptions we can convert the income statement into a variable form.  The table below contains both full costing and variable costing forms of the income statement.

Notes:

Variable COGS = 100% of COGS            

Variable SG&A = 30% of SG&A               

Variable Credit card expenses Target = 20%                 

Depreciation and amortization Target 100% fixed                    

In the above we allow for the fact that Target has one additional line item “Other” which is primarily fixed cost.  Observe that the fixed component of both costs is a little higher for Target than Wal-Mart.

Finally, a firm’s operating leverage is defined as the percentage change in the firm’s operating earnings (EBIT less any non-operating income), that accompanies a percentage change in the contribution margin.  That is, the operating income elasticity with respect to the contribution margin.  In other words, this tells an analyst that a percentage change in sales revenue will result in a percentage change in operating earnings.  This is a useful number to estimate especially as the consensus sales revenue forecast is readily available in the form of high, low and average which can then be related to earnings forecasts via the following relationship:

Equivalently,

This important measure reflects the fact that a change in Sales can lead to a more than proportional change in earnings from operations.  In particular, the higher the degree of operating leverage the higher the predicted change.  However, the relative size of the Degree of Operating Leverage is affected by how close the firm is to their break-even point.  The closer the higher is the DOL.

From the above variable costing income statement for the year ending:

In the above example observe that Target has a higher contribution margin than does Wal-Mart.  Thus all other things being equal Target is prepared to spend more on advertising because the dollar contribution from increased sales is higher.  However, observe the degree of operating leverage is higher for Wal-Mart than Target.  This implies increasing advertising expenditure to increase sales will have a greater impact on Operating Income for Wal-Mart than Target.  That is, the latter measure takes into account both fixed and variable costs.  Income from Operations is an important number in later assessments of intrinsic value.  As a result, it is a number that provides a broader measure of expenditures upon a firm’s assessed value.