3 elements of risk can explain differences across firms and changes over time in earnings and ROA Cyclicality of Sales Product Life Cycle Companies in high margin, low turnover businesses need to Companies in low margin, high turnover businesses strive to Operating leverage economies of scale diseconomies of scale

1. 3 elements of risk can explain differences across firms and changes over time in earnings and ROA

1. cyclicality of sales
2. stage and length of product life cycle
3. operating leverage

2. Cyclicality of Sales

sensitivity to business cycle
- sales revenue can decrease substantially when the economy slows

3. Product Life Cycle

ROA increases significantly during growth phase, firms continue to increase ROA into maturity phase by cutting costs and improving efficiency, and declines during the decline phase of the life cycle when increased competition or reduced demand reduces pricing power.

4. Companies in high margin, low turnover businesses need to

constantly innovate. Drug companies need new drugs in the pipeline to counter the margin pressures from older drugs that will lose patent protection.

5. Companies in low margin, high turnover businesses strive to

become the lowest cost producers. Lower costs can increase profit margins, or facilitate higher market share through price cuts.

6. Operating leverage

Firms with high proportions of fixed costs ( such as airlines, utilities, petroleum refiners)

7. economies of scale

when firms experience significant increases in operating income as sales increase.

8. diseconomies of scale.

when sales decrease, firms experience sharp decreases in operating income

9. Why does economies of scale occur?

because the firms spread fixed costs over a larger number of units sold, resulting in a decrease in average unit cost.

10. Firms with _____ levels of operating leverage experience greater variability in ROA than firms with ______ levels of operating leverage.

high, low