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From static to dynamic cost structures: The case of the railroad industry
Author(s) -
Rozycki John,
Suh Inchul,
Root Thomas
Publication year - 2020
Publication title -
journal of corporate accounting and finance
Language(s) - English
Resource type - Journals
eISSN - 1097-0053
pISSN - 1044-8136
DOI - 10.1002/jcaf.22472
Subject(s) - operating leverage , leverage (statistics) , revenue , fixed cost , valuation (finance) , variable cost , cash flow , earnings , operating cash flow , economics , business , capital structure , monetary economics , earnings before interest and taxes , industrial organization , finance , microeconomics , debt , computer science , machine learning , profitability index
Firms with fixed operating costs have high operating leverage. This leverage increases the sensitivity of earnings before interest and taxes (EBIT) to changes in revenues. Railroads have high fixed costs and high operating leverage. One would rationally expect that a substantial and secular decline in this industry's revenues would lead to severe and negative effects on operating income and free cash flow. The industry did indeed experience a secular decline in its most important business segment, hauling bituminous coal. In this clinical investigation, we use this unique industry event to study operating leverage and changes to the industry's cost structure. Using several methodologies, we measure the changes in the industry's cost structure and we demonstrate how the changes mitigated the expected negative effects of its revenue decline. Additionally, we demonstrate that static measures of an industry's cost structure are likely to produce suboptimal forecasts. Finally, our findings have implications for financial planning and valuation of firms with high operating leverage, and they provide a renewed impetus for research into the dynamic relationship between fixed and variable costs.