DDKM Casio Inc.: The Risk-Reward Trade Off From Operating Leverage*

DDKM Casio Inc.: The Risk-Reward Trade Off From Operating Leverage

The Confrontation

As a new hire at DDKM Casio’s (Pro audio and Audio Visual equipments manufacturer in India), Smith was perplexed with the task of evaluating proposals for enhancing the company’s production process. His production manager, Ariana suggested him to opt for a new technology that could create designer keys for DDKM Casio’s. Keeping in view the external and internal factors of the organization such as fierce competition, use of outdated keys and shrinking profits Ariana came up with a proposal of using a new technology which could lead to manufacturing of designer keys for DDKM Casio’s.

For quite some time the sales department proclaimed that revenues of DDKM were depleting because of using outdated keys than its competitors. Meanwhile, Ariana’s constant pestering for approving the proposal of using a better technology irritated Smith. She further mentioned how using a better technology might increase the fixed cost of operations but will help in decreasing the variable costs leading to an elevation in the margin per Casio. With the predictable boost in sales volume, there should not be any challenge in covering the elevated fixed expenses and still produce higher net operating income. Ariana knew of a resource who could help DDKM disassemble their old production line............................

DDKM Casio Inc.: The Risk-Reward Trade Off From Operating Leverage

Synopsis

A concept that is uniquely covered in each textbook of accounting and essentials of finance is operating leverage which measures the degree to which a firm or a project incurs a combination of fixed and variable cost. This caselet studies the impact of changes in cost components on the Net Operating income of the business. This study extends the relationship between Sales and Net operating Income by illustrating a numerical and graphical example. Also, a teaching note is planned to provide a detailed explanation of the case to the instructor thereby giving students a better understanding of the risk-return implications of Operating Leverage.

Teaching Objectives

The case enables the students to learn:

1. Beyond the simple, end-of-chapter problems dealing with operating leverage, using a fictitious case involving a technically improved production process with higher fixed costs and lower variable costs to demonstrate the risk-reward trade-off implicit in the operating leverage decision. Students must not only compute the degree of operating leverage (DOL) with both the existing and novel technologies but also show graphically the greater risk-reward trade-off inherent in the new technology.

2. Demonstrate the notion of operating leverage as a decision criterion in analyzing a proposed change in the production process.

3. Use basic statistical analysis to examine the risk-reward trade-off from taking on a proposed new technology characterized by greater operating leverage than the firm’s current technology. [Note: The analytics of the risk-reward trade-off draws heavily on the discussion of operating leverage in Gia Chevis and John T. Rose, “Clarifying the Risk-Return Implications of Operating Leverage as presented in the Sales-NOI Relationship,” Journal of Financial Education, 39:1/2 (Spring/Summer 2013), pp. 66-78.] Also, to increase experience in investigative what if?” questions by varying the standard deviation of the probability distribution of predictable sales in order to see the implication for the risk-reward trade-off from the greater leverage of operations.

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