Cost Swaps And Risk: An Analysis Of The Effect Of Cost Swaps On Degree Of Operating Leverage And Break-Even Points

Abstract

<p class="MsoNormal" style="text-align: justify; margin: 0in 0.5in 0pt; mso-pagination: widow-orphan;"><span style="font-family: "CG Times","serif";"><span style="font-size: x-small;">Financial institutions have, for a long time, used interest rate swaps to address risk in managing assets and liabilities.<span style="mso-spacerun: yes;">   </span>Variable interest streams can be “swapped” for fixed payment streams (or visa versa) to either increase or decrease the sensitivity of the financial institution’s profits to changes in interest rates.<span style="mso-spacerun: yes;">  </span>With the advent of outsourcing, all businesses have the ability to do essentially the same thing by swapping fixed or variable cost streams.<span style="mso-spacerun: yes;">  </span>This article addresses managerial accounting topics of break-even analysis and degree of operating leverage which both have implications on risk and cost of capital.<span style="mso-spacerun: yes;">   </span>The analysis demonstrates a point that is generally ignored in the treatment of these issues.<span style="mso-spacerun: yes;">  </span>Conventional understanding says that shifting costs from variable to fixed will increase both the break-even point and degree of operating leverage.<span style="mso-spacerun: yes;">   </span>The analysis demonstrates that this is not necessarily true and could, indeed, have the opposite effect.<span style="mso-spacerun: yes;">  </span>The analysis also provides the conditions for determining how a shift in cost will impact break-even points and degree of operating leverage.<span style="mso-spacerun: yes;">  </span>The analysis is timely and offers insights to managers as to how outsourcing can be used to address the management of risk. </span></span></p>