Is the Cost Structure Always Indicative of Operating Risk?

Various textbooks in management accounting associate the concept of degree of operating leverage (DOL) to the ratio of fixed costs and variable costs—an index referred to as the cost structure of a firm. This view of operating leverage implies that, if two firms have different sales volumes and operating costs, the one with a higher proportion of fixed-to-variable costs is surely riskier than the other. Moreover, it also suggests that firms that change their cost structure (e.g., by swapping fixed costs to variable costs) are always affecting the volatility of their earnings—hence, their operating risk. The aim of this work is to discuss the factors that determine operating leverage and to analytically and empirically show that the cost structure is not necessarily correlated with operating risk. In doing so, I compare the methods used by extant research to estimate DOL. Using simulation analysis, I find that the method that proxies DOL through the cost structure is the least accurate