From static to dynamic cost structures: The case of the railroad industry

• Published in: The Journal of corporate accounting & finance 2020-10, Vol.31 (4), p.166-177
• Main Authors: Rozycki, John, Suh, Inchul, Root, Thomas
• Format: Article
• Language: English
• Subjects: Cash flow; coal; cost structure; Costs; degree of operating leverage; elasticity; electric power generation; Fixed costs; Operating leverage; railroad industry; variable costs
• ISSN: 1044-8136; 1097-0053
• DOI: 10.1002/jcaf.22472

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.