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how the opening cross works | nasdaq s regular trading hours are between 9 30 a m and 4 00 p m eastern time monday through friday however nasdaq accepts trade requests for several hours after the market closes and several hours before it opens the process for the opening cross consolidates these requests and conducts an auction buyers and sellers place offers and counteroffers until prices match resulting in trades the goal is to maximize the number of executed trades by getting a given security to trade at a single price nasdaq makes the resulting data available electronically this gives market participants a greater window into the bid ask spread and helps identify order imbalances and situations where buyers and sellers cannot be matched nasdaq market on open orders can be placed changed or canceled from 7 30 a m until 9 28 a m eastern time on the days the exchange is open under the open cross system price matches use a 10 threshold or buffer to calculate the opening price of a stock for example if a buyer offers 100 per share for a given stock and a seller wants 110 the midpoint of the offer is 105 this midpoint is then multiplied by 10 the resulting 10 50 is then added to the buyer s offering price moving it to 110 50 and subtracted from the seller s price adjusting it to 99 50 this tells investors that the opening price for the shares is between 99 50 and 110 50 the opening cross calculates this for all stocks and provides updated information electronically every five seconds in addition the open cross system shows detailed information about the prices at which orders are expected to clear against each other the number of paired buy sell offers and the imbalance between offers as potential buyers and sellers see this data they make additional trades which the system also incorporates | |
when does the nasdaq start releasing information on order imbalances for the opening cross | nasdaq releases information on order imbalances for the opening cross starting at 9 28 a m on trading days 1 | |
is there a closing cross | yes nasdaq uses a similar process when the market closes at 4 p m this is called the closing cross and is used to determine the closing price of shares 1 | |
why is it important to have a clear opening price | having a clear opening price is important for traders because many rely on the opening price and later price movements to indicate whether a stock will rise or fall it also helps reduce uncertainty for investors who wish to buy shares soon after the market opens without a way to give each stock a clear opening price there could be wide bid ask spreads at market open which would make trading more difficult and costly | |
when is the deadline to submit an order for the opening cross | orders for the opening cross should be submitted before 9 28 a m orders submitted after 9 28 a m are considered late regular hours orders and treated as imbalance only orders 1 buy orders only execute at or below the 9 30 a m ask while sell orders execute at or above the 9 30 a m bid price these orders help add liquidity during the opening cross the bottom linethe opening cross is an important process that allows nasdaq to display clear opening prices to investors it also permits investors to buy or sell shares as soon as the market opens without having to worry about large bid ask spreads or a muddy pricing picture that would affect trading | |
what is an opening imbalance only order oio | opening imbalance only orders oio are a type of limit order that provides liquidity during the opening cross on the nasdaq a limit order is an order placed with a brokerage to execute a buy or sell transaction at a set number of shares and a specified limit price breaking down opening imbalance only order oio opening imbalance only oio orders are only executable on the opening cross and are not displayed or disseminated oio buy orders only execute at or below the 9 30 a m bid price while oio sell orders only execute at or above the 9 30 a m offer price oio orders must necessarily be limit orders and market oio orders are not permitted since oio orders are only executable during the opening cross they are not at risk of being executed prior to market open unlike continuous market orders 1 oio buy or sell orders priced more aggressively than the 9 30 a m nasdaq highest bid or lowest offer prior to market open will be re priced to the nasdaq bid or offer before the opening cross is executed 1 so for example if an oio buy order price is 9 95 and the nasdaq bid is at 9 93 the oio order will be re priced to 9 93 this adds liquidity to the market and helps ensure that market on open moo and limit on open loo orders are properly executed oio orders are accepted on the nasdaq from 7 a m onward however market participants cannot update these orders after 9 28 a m although new oio orders can still be entered after that time 2 nasdaqopening imbalance only orders oios are executed within the nasdaq nasdaq is a global electronic marketplace for buying and selling securities and also serves as the benchmark index for u s technology stocks the national association of securities dealers nasd created nasdaq to enable investors to trade securities on a computerized and transparent system in 2006 nasdaq officially separated from the nasd and began to operate as a national securities exchange 3 the term nasdaq is also used to refer to the nasdaq composite which is an index of more than 2 500 stocks listed on the nasdaq exchange that include some of the world s largest technology and biotech giants such as apple google microsoft oracle amazon intel and amgen nasdaq has been a leader in trading technology from its inception the nasdaq computerized trading system was initially devised as an alternative to the inefficient specialist system which had been the prevalent model for trading for nearly 100 years today due to rapid technological advancements nasdaq s electronic trading model is the standard for markets worldwide | |
how opening price works | the nasdaq uses the opening cross approach to calculate opening prices based on the orders that accumulated overnight typically a security s opening price differs from the last day s closing price 1 after hours trading has changed investor valuations or expectations for the security factors that can affect the opening priceafter the market closes corporate announcements and other news can change investor expectations and the next day s opening price some investors may try to buy or sell securities when large scale disasters occur after hours not all orders are executed during after hours trading there is much less liquidity during this time producing wider bid ask spreads this makes orders unattractive because it s more challenging to complete a transaction at a predictable price and limit orders often won t be filled | |
when the market opens the next day this large amount of limit or stop orders placed at prices different from the prior day s closing price causes a discrepancy between supply and demand this causes the opening price to move off the previous day s close toward prices corresponding to the overnight changes | while predicting stock prices has led to financial ruin for even the best investors there are some ways to gauge a market s opening direction the most obvious is to review the after hours or premarket activity some investors trade shares outside the stock market s regular trading hours though the volume traded is almost always lower if a stock increases in value after hours and there s no significant news overnight there s a good chance the stock will have an opening price above the previous day s closing price the same applies of course if it decreases overnight premarket trading happens before the market opens so the price at which premarket trades occur can also be a helpful way to predict the opening price many investors also review what s happening in international markets to gauge how the opening will go trading hours vary from country to country but typically align with regular work hours for example in japan trading occurs from 9 a m to 11 30 a m and 12 30 p m to 3 p m local time that is it opens at 7 p m and closes at 1 a m eastern time 2while many factors influence the prices of stocks across different markets if another country s markets rose while the american stock market was closed investor sentiment is often that the american market is likely to open higher than its closing price opening price trading strategiesthere are several day trading strategies based on the opening of a market when the opening price is quite different from the prior day s close that creates a price gap day traders use a strategy known as the gap fade and fill traders try to profit from the price correction that usually occurs when there s a sizable price gap at the opening another popular strategy is to fade a stock showing strong premarket indications contrary to the rest of the market or similar securities when a disparity is present from premarket signals a trader waits for the stock to move at the open going against the rest of the market the trader then takes a position in the stock in the market s general direction when the momentum and volume of the initial contrasting stock price movement diminishes when done correctly these are high probability strategies designed to achieve quick small profits opening price exampleon jan 10 2024 the opening price for apple aapl was 184 70 the stock rose to a high of 186 36 but it closed at 186 19 3can you buy a stock at opening price yes it s possible to buy a stock at its opening price if you place a market on open order to buy a stock before the market opens you ll buy shares at the opening price | |
what is the 10 a m rule | some traders follow something called the 10 a m rule the stock market opens for trading at 9 30 a m and the time between 9 30 a m and 10 a m often has significant trading volume traders that follow the 10 a m rule think a stock s price trajectory is relatively set for the day by the end of that half hour for example if a stock closed at 40 the previous day opened at 42 the next and reached 43 by 10 a m this would indicate that the stock is likely to remain above 42 by market close | |
are there strategies for trading based on the closing price of a stock | yes several strategies are used that focus on the closing price of a stock the closing price the last price at which a stock trades during a regular session is the focus of the end of day trading strategies which involves deciding trades based on the price moves at the end of the trading day traders look for signals from the closing price to predict the next day s market direction a prominent method is the closing price reversion strategy where if a stock s closing price deviates significantly from its historical average traders try to profit should it revert to the mean closing price breakout strategies involve looking for stocks whose closing prices have broken out of a particular range for instance a breakout above a resistance level could indicate a bullish trend the bottom linethe opening price for a stock is the price it trades immediately after the stock market opens at 9 30 a m eastern time it can be close to the price at the previous day s market close or shift significantly because of overnight news knowing the opening price for a stock and how it changes because of overnight trading is crucial information especially for those trading early in the day | |
what is the opening range | the term opening range or refers to a security s high and low price for a short period just after the market opens often the first fifteen minutes of the trading day day traders often monitor a stock s opening range because it can provide an indication of market sentiment and price trends for the day they often use the opening range to help secure and maximize their profitsunderstanding the opening rangethe opening range is one of several price ranges that technical analysts follow when watching a chart trading ranges in general can be a powerful indicator for technical analysts the opening range often shows strength weakness or a sideways trend with no clear sentiment most charts display the day s high and low which shows the exact trading range from open through the current time period many investors follow the opening range of a security s price before or after a significant announcement such as when a company releases its quarterly earnings report to gauge price direction investors may also choose to follow a stock s opening range to consider its sentiment in conjunction with a potential trading idea traders can use varying patterns other forms of technical analysis and multiple timeframes to track the opening range a stock s opening price in comparison to the previous day s closing price for example may help determine the day s trend traders can then apply bollinger bands which provide a hypothetical support and resistance band drawn two standard deviations above and below a stock price s moving average | |
when the price violates the opening range band traders can position for either a breakout or reversion to the mean some investors may choose to follow only a few minutes of the opening price action while others may prefer to see an hour or more before drawing a conclusion from the opening range | example of opening range tradinginvestors and traders can monitor opening ranges using a variety of charting resources the chart below shows the opening range of the social networking service x formerly twitter several days after the company released its 2019 second quarter earnings the opening range between the dotted trendlines shows the first 25 minutes of trading activity with the stock s price printing a low at 41 08 and a high at 41 65 a breakout at 9 55 a m above the opening range and the previous day s high gives traders an indication of further upside intraday momentum and to favor long positions over short positions image by sabrina jiang investopedia 2021stop loss orders could sit below the breakout candle or beneath the opening range low depending on preferred risk tolerance traders may decide to take profits using a multiple of risk for example if using a 30 cent stop traders might set a 60 cent profit target alternatively traders may implement a trailing stop such as exiting if the price closes below a moving average to let profits run for example those who used this exit strategy got stopped out at 11 50 a m when the stock s price closed below the 10 period simple moving average sma x s stock was officially delisted on nov 8 2022 after it was taken private by elon musk 1 | |
why is the opening range important | the opening range is important for some traders as it can be a period of high volume and volatility that then sets the tone for the rest of the trading day indeed some research points to the fact that a day s high or low being printed during the opening minutes of trading is far more frequent than a random walk would suggest 2 | |
how do day traders use the opening range | day traders frequently use the trading range of the first half hour of the trading session as a reference point for their intraday strategies for example a trader might buy a stock if it breaks above its opening trading range | |
what is an at the opening order | an at the opening order instructs one s broker to buy or sell a security for their account right at the very beginning of the trading day if the order cannot be executed at the opening of the market it will be canceled the bottom linetraders look at many different variables when they re making their investment decisions the opening range is one of those tools this is the high and low price of an asset shortly after the market opens the or helps traders because it can help them understand the tone of the trading day ahead in terms of market sentiment and price as such it s an easily understood strategy with identifiable entry and exit points | |
what are operating activities | operating activities are the functions of a business directly related to providing its goods and or services to the market these are the company s core business activities such as manufacturing distributing marketing and selling a product or service operating activities will generally provide the majority of a company s cash flow and largely determine whether it is profitable some common operating activities include cash receipts from goods sold payments to employees taxes and payments to suppliers these activities can be found on a company s financial statements and in particular the income statement and cash flow statement operating activities are distinguished from investing or financing activities which are functions of a company not directly related to the provision of goods and services instead financing and investing activities help the company function optimally over the longer term this means that the issuance of stock or bonds by a company are not counted as operating activities key operating activities for a company include manufacturing sales advertising and marketing activities investopedia zoe hansenthe basics of operating activitiesoperating activities are the daily activities of a company involved in producing and selling its product generating revenues as well as general administrative and maintenance activities the operating income shown on a company s financial statements is the operating profit remaining after deducting operating expenses from operating revenues there is typically an operating activities section of a company s statement of cash flows that shows inflows and outflows of cash resulting from a company s key operating activities in the event of ambiguity operating activities can readily be identified by classification in financial statements many companies report operating income or income from operations as a specific line on the income statement operating income is calculated by subtracting the cost of sales cogs research and development r d expenses selling and marketing expenses general and administrative expenses and depreciation and amortization expenses operating income excludes interest income or expenses for example an apparel store s operating activities might include the following other less common operating activities include fines or cash settlements from lawsuits refunds and money collected from insurance claims the key operating activities that produce revenues for a company are manufacturing and selling its products or services sales activities can include selling the company s own in house manufactured products or products supplied by other companies as in the case of retailers companies that primarily sell services may or may not also sell products for example a spa business in addition to providing services such as massages may also seek additional revenue income from the sale of health and beauty products interest and dividend income while part of overall operational cash flow are not considered to be key operating activities since they are not part of a company s core business activities expenses generated from key operating activities include manufacturing costs as well as the expenses of advertising and marketing the company s products or services manufacturing costs include all the direct production costs included in cost of goods sold cogs operating costs related to advertising and marketing include the expenses of advertising the company and its products or services using various media outlets whether through traditional or online platforms in addition marketing costs include such things as appearing at trade shows and participating in public events such as charity fundraisers cash flows from operating activities are among the major subsections of the statement of cash flows it is separate from the sections on investing and financing activities investing activities refer to earnings or expenditures on long term assets such as equipment and facilities while financing activities are the cash flows between a company and its owners and creditors from activities such as issuing bonds retiring bonds selling stock or buying back stock to get an accurate picture of a company s cash flow from operating activities accountants add depreciation expenses losses decrease in current assets and increases in current liabilities to net income and then subtract gains increases in current assets and decreases in current liabilities investors examine a company s cash flow from operating activities separately from the other two components of cash flow to see where a company is really getting its money investors want to see positive cash flow because of positive income from operating activities which are recurring not because the company is selling off all its assets which results in one time gains the company s balance sheet and income statement help round out the picture of its financial health an example of cash flow from operating activitieslet s look at the cash flow details of the leading technology company apple inc aapl the iphone maker reported the following for the fiscal year ended september 2017 following the first formula the summation of these numbers brings the value for funds from operations as 69 15 billion the net change in working capital for the same period was 5 55 billion adding it to funds from operations gives the cash flow from operating activities for apple as 69 15 5 55 63 6 billion 1 | |
what is operating cash flow ocf | operating cash flow ocf is cash generated by a company s normal business operations it helps determine whether a company generates sufficient positive cash flow to maintain and grow its operations without external financing a company s statement of cash flows includes three types of cash flows operating investing and financing operating cash flows measure the inflows and outflows related to a company s main business activities such as selling and purchasing inventory providing services and paying salaries any investing and financing transactions such as borrowing buying capital equipment and making dividend payments are excluded investopedia dennis madambaaccounting for operating cash flow ocf operating cash flow represents the cash impact of a company s net income ni from its primary business activities operating cash flow also referred to as cash flow from operating activities is the first section of the cash flow statement operating cash flow provides a clear picture of the reality of the business operations for example a large sale boosts revenue but if the company is having difficulty collecting the cash the sale is not a true benefit for the company on the other hand a company may generate high amounts of operating cash flow but report low net income if it has a lot of fixed assets and uses accelerated depreciation calculations a company not bringing in enough money from core business operations may need to find temporary external funding through financing or investing however this is unsustainable in the long run operating cash flow helps assess the financial stability of a company s operations the operating cash flow section can be presented under generally accepted accounting principles gaap by the indirect or direct method if the direct method is used the company must still perform a separate reconciliation to the indirect method 12the operating cash flow ratio represents a company s ability to pay its debts with its existing cash flows it is determined by dividing operating cash flow by current liabilities a ratio greater than 1 0 indicates that a company is in a strong position to pay its debts without incurring additional liabilities | |
what is operating cash flow demand ocfd | the term operating cash flow demand ocfd refers to the amount of operating cash flow an entity needs in order to meet the objectives of its strategic investments an ocfd is integral for both investors and corporate entities for investors it represents the total amount of capital required in order to the desired return over the entire life of the investment a company s ocfd on the other hand is used to compute the cash value added to a company s strategic investments and operations the ocfd allows entities to make smart decisions about how they spend their money on certain investments understanding operating cash flow demand ocfd a strategic investment is any investment that allows an investor to achieve a specific goal an individual who wants to generate a steady risk free stream of income may choose a bond as a strategic investment to achieve this goal a corporation may enter a joint venture with another company as a joint venture in order to gain access to another market all in all strategic investment is one that fits the investor s short or long term game plan investors need capital or operating cash flow in order to meet the initial and ongoing needs of their investments the operating cash flow demand ocfd therefore is the amount of cash flow needed for each strategic investment to have a net present value of zero or achieve minimum profitability 1as noted above calculating the ocfd helps entities make wiser decisions about their investments this figure effectively helps investors decide whether to approve or reject the idea of a particular investment if the cost of the investment is worth more than the benefit the investor can nix the deal 2example of operating cash flow demand ocfd let s use the hypothetical example of a manufacturing corporation to show how operating cash flow demands work let s say the company wants to enter a new market in order to do so it must make a strategic investment in a new manufacturing plant and new machinery the ocfd for this strategic investment would be the minimum amount of cash that the plant would need to generate over its life to meet the return required by investors the amount of money a company expects to earn determines how much it pays for the investment so if a company wants to earn more it should plan to pay more for a strategic investment real world example of operating cash flow demand ocfd now let s take a look at how operating cash flow demand works with a real life example this one involves gud holdings an australian company that is the corporate parent for national household brands ryco filters sunbeam davey pumps lock focus and others ian campbell served as the company s chief executive officer ceo between 1998 and 2013 3 at that time the company was struggling financially this was primarily due to a series of acquisitions the company made in an attempt to grow and boost its presence in the market campbell used a leadership style that combined focus and discipline leading gud holdings to profitability 4campbell expected his company manager to generate strong financial results for a key performance indicator cash value added cva this benchmark is related to ocfd cash value added is a measure of a company s ability to generate cash flow in excess of its investors required return on investments roi by the company 4as ceo campbell expected each gud division to exceed 10 weighted average cost of capital wacc which is the average rate that a company is expected to pay all its security holders to finance its assets gud s businesses are judged on the growth in the cash value added compared to the prior year campbell set an annual budget for each division the wacc varied between businesses managers received bonuses if they achieved their targets 4 | |
what is the operating cash flow margin | operating cash flow margin is a cash flow ratio that measures cash from operating activities as a percentage of total sales revenue in a given period like operating margin it is a trusted metric of a company s profitability and efficiency and its earnings quality | |
what is the operating cash flow ratio | the operating cash flow ratio is a measure of how readily current liabilities are covered by the cash flows generated from a company s operations this ratio can help gauge a company s liquidity in the short term using cash flow as opposed to net income is considered a cleaner or more accurate measure since earnings are more easily manipulated investopedia julie bangthe formula for the operating cash flow ratiooperating cash flow ratio operating cash flow current liabilities text operating cash flow ratio frac text operating cash flow text current liabilities operating cash flow ratio current liabilitiesoperating cash flow the operating cash flow ratio is calculated by dividing operating cash flow by current liabilities operating cash flow is the cash generated by a company s normal business operations a company generates revenues and deducts the cost of goods sold cogs and other associated operating expenses such as attorney fees and utilities from those revenues cash flow from operations is the cash equivalent of net income it is the cash flow after operating expenses have been deducted and before the commencement of new investments or financing activities investors tend to prefer reviewing the cash flow from operations over net income because there is less room to manipulate results however together cash flows from operations and net income can provide a good indication of the quality of a firm s earnings current liabilities are all liabilities due within one fiscal year fy or operating cycle whichever is longer they are found on the balance sheet and are typically regarded as liabilities due within one year understanding the operating cash flow ratiothe operating cash flow ratio is a measure of the number of times a company can pay off current debts with cash generated within the same period a high number greater than one indicates that a company has generated more cash in a period than what is needed to pay off its current liabilities an operating cash flow ratio of less than one indicates the opposite the firm has not generated enough cash to cover its current liabilities to investors and analysts a low ratio could mean that the firm needs more capital however there could be many interpretations not all of which point to poor financial health for example a firm may embark on a project that compromises cash flows temporarily but renders substantial rewards in the future the operating cash flow ratio vs the current ratioboth the operating cash flow ratio and the current ratio measure a company s ability to pay short term debts and obligations the operating cash flow ratio assumes cash flow from operations will be used to pay those current obligations i e current liabilities the current ratio meanwhile assumes current assets will be used example of the operating cash flow ratioconsider two giants in the retail space walmart and target as of feb 27 2019 the two had current liabilities of 77 5 billion and 17 6 billion respectively over the trailing 12 months walmart had generated 27 8 billion in operating cash flow while target generated 6 billion the operating cash flow ratio for walmart is 0 36 or 27 8 billion divided by 77 5 billion target s operating cash flow ratio works out to 0 34 or 6 billion divided by 17 6 billion the two had similar ratios meaning they had similar liquidity digging deeper we find that the two also shared similar current ratios as well further validating that they indeed had similar liquidity profiles limitations of using the operating cash flow ratioalthough not as prevalent as with net income companies can manipulate operating cash flow ratios some companies deduct depreciation expenses from revenue even though it does not represent a real outflow of cash depreciation expense is an accounting convention that is meant to write off the value of assets over time as a result companies should add depreciation back to cash in cash flow from operations | |
what are operating costs | operating costs are associated with the maintenance and administration of a business on a day to day basis operating costs include direct costs of goods sold cogs and other operating expenses often called selling general and administrative sg a which include rent payroll and other overhead costs as well as raw materials and maintenance expenses operating costs exclude non operating expenses related to financing such as interest investments or foreign currency translation the operating cost is deducted from revenue to arrive at operating income and is reflected on a company s income statement investopedia joules garciaunderstanding operating costsbusinesses have to keep track of operating costs as well as the costs associated with non operating activities such as interest expenses on a loan both costs are accounted for differently in a company s books allowing analysts to determine how costs are associated with revenue generating activities and whether the business can be run more efficiently generally speaking a company s management will seek to maximize profits for the company because profits are determined both by the revenue that the company earns and the amount the company spends in order to operate profit can be increased both by increasing revenue and by decreasing operating costs because cutting costs generally seems like an easier and more accessible way of increasing profits managers will often be quick to choose this method trimming operating costs too much can reduce a company s productivity and as a result its profit as well while reducing any particular operating cost will usually increase short term profits it can also hurt the company s earnings in the long term for example if a company cuts its advertising costs its short term profits will likely improve since it is spending less money on operating costs however by reducing its advertising the company might also reduce its capacity to generate new business such that earnings in the future could suffer ideally companies look to keep operating costs as low as possible while still maintaining the ability to increase sales | |
how to calculate operating costs | the following formula and steps can be used to calculate the operating cost of a business you will find the information needed from the firm s income statement that is used to report the financial performance for the accounting period operating cost cost of goods sold operating expenses text operating cost text cost of goods sold text operating expenses operating cost cost of goods sold operating expensestypes of operating costswhile operating costs generally do not include capital outlays they can include many components of operating expenses such as operating costs will also include the cost of goods sold which are the expenses directly tied to the production of goods and services some of the costs include a business s operating costs are comprised of two components fixed costs and variable costs which differ in important ways fixed costsa fixed cost is one that does not change with an increase or decrease in sales or productivity and must be paid regardless of the company s activity or performance for example a manufacturing company must pay rent for factory space regardless of how much it is producing or earning while it can downsize and reduce the cost of its rent payments it cannot eliminate these costs and so they are considered to be fixed fixed costs generally include overhead costs insurance security and equipment fixed costs can help in achieving economies of scale as when many of a company s costs are fixed the company can make more profit per unit as it produces more units in this system fixed costs are spread out over the number of units produced making production more efficient as production increases by reducing the average per unit cost of production economies of scale can allow large companies to sell the same goods as smaller companies for lower prices the economies of scale principle can be limited in that fixed costs generally need to increase with certain benchmarks in production growth for example a manufacturing company that increases its rate of production over a specified period will eventually reach a point where it needs to increase the size of its factory space in order to accommodate the increased production of its products variable costsvariable costs like the name implies are comprised of costs that vary with production unlike fixed costs variable costs increase as production increases and decrease as production decreases examples of variable costs include raw material costs and the cost of electricity in order for a fast food restaurant chain that sells french fries to increase its fry sales for instance it will need to increase its purchase orders of potatoes from its supplier it s sometimes possible for a company to achieve a volume discount or price break when purchasing supplies in bulk wherein the seller agrees to slightly reduce the per unit cost in exchange for the buyer s agreement to regularly buy the supplies in large amounts as a result the agreement might diminish the correlation somewhat between an increase or decrease in production and an increase or decrease in the company s operating costs for example the fast food company may buy its potatoes at 0 50 per pound when it buys potatoes in amounts of less than 200 pounds however the potato supplier may offer the restaurant chain a price of 0 45 per pound when it buys potatoes in bulk amounts of 200 to 500 pounds volume discounts generally have a small impact on the correlation between production and variable costs and the trend otherwise remains the same typically companies with a high proportion of variable costs relative to fixed costs are considered to be less volatile as their profits are more dependent on the success of their sales in the same way the profitability and risk for the same companies are also easier to gauge semi variable costsin addition to fixed and variable costs it is also possible for a company s operating costs to be considered semi variable or semi fixed these costs represent a mixture of fixed and variable components and can be thought of as existing between fixed costs and variable costs semi variable costs vary in part with increases or decreases in production like variable costs but still exist when production is zero like fixed costs this is what primarily differentiates semi variable costs from fixed costs and variable costs an example of semi variable costs is overtime labor regular wages for workers are generally considered to be fixed costs as while a company s management can reduce the number of workers and paid work hours it will always need a workforce of some size to function overtime payments are often considered to be variable costs as the number of overtime hours that a company pays its workers will generally rise with increased production and drop with reduced production when wages are paid based on conditions of productivity allowing for overtime the cost has both fixed and variable components and is considered to be a semi variable cost real world example of operating costsbelow is the income statement for apple inc aapl for the year ending sept 25 2021 according to its annual 10 k report apple s total operating costs must be examined over several quarters to get a sense of whether the company is managing its operating costs effectively also investors can monitor operating expenses and cost of goods sold or cost of sales separately to determine whether costs are either increasing or decreasing over time sg a vs operating costsselling general and administrative expense sg a is reported on the income statement as the sum of all direct and indirect selling expenses and all general and administrative expenses g a of a company it includes all the costs not directly tied to making a product or performing a service that is sg a includes the costs to sell and deliver products or services in addition to the costs to manage the company sg a includes nearly everything that isn t in the cost of goods sold cogs operating costs include cogs plus all operating expenses including sg a limitations of operating costsas with any financial metric operating costs must be compared over multiple reporting periods to get a sense of any trend companies sometimes can cut costs for a particular quarter which inflates their earnings temporarily investors must monitor costs to see if they re increasing or decreasing over time while also comparing those results to the performance of revenue and profit | |
what is the total cost formula | the total cost formula combines a firm s fixed and variable costs to produce a quantity of goods or services to calculate the total cost add the average fixed cost per unit to the average variable cost per unit multiply this by the total number of units to derive the total cost the total cost formula is important because it helps management calculate the profitability of their business it helps managers pinpoint which fixed or variable costs could be reduced to increase profit margins it also helps managers determine the price point for their products and compare the profitability of one product line versus another | |
how do operating costs affect profit | operating costs that are high or increasing can reduce a company s net profit a company s management will look for ways to stabilize or decrease operating costs while still balancing the need to manufacture goods that meet consumer demands if operating costs become too high management may need to increase the price of their products in order to maintain profitability they then risk losing customers to competitors who are able to produce similar goods at a lower price point | |
what is the difference between operating costs and startup costs | operating costs are the expenses a business incurs in its normal day to day operations startup costs on the other hand are expenses a startup must pay as part of the process of starting its new business even before a business opens its doors for the first time or begins production of a new product it will have to spend money just to get started for example the business may need to spend money on research and development equipment purchases a lease on office space and employee wages a startup often pays for these costs through business loans or money from private investors this contrasts with operating costs which are paid for through revenue generated from sales | |
what are operating earnings | operating earnings is a corporate finance and accounting term that isolates the profits realized from a business s core operations specifically it refers to the amount of profit realized from revenues after you subtract those expenses that are directly associated with running the business such as the cost of goods sold cogs general and administration g a expenses selling and marketing research and development depreciation and other operating costs operating earnings are an important measure of corporate profitability because the metric excludes non operating expenses such as interest payments and taxes it enables an assessment of how well the company s chief lines of business are doing understanding operating earningsoperating earnings lie at the heart of both internal and external analysis of how a company is making money as well as how much money it s making the individual components of operating costs can be measured relative to total operating costs or total revenues to assist management in running a company operating earnings are usually found within a company s financial statements specifically towards the end of the income statement though it gets close to the nitty gritty operating earnings aren t quite the famed bottom line that truly signals how well or how poorly a firm is faring that status belongs to a company s net income net indicating what remains after deducting taxes debt repayments interest charges and all the other non operating debits a business has encountered operating earnings is a term that can be used interchangeably with operating income operating profit and earnings before interest and taxes ebit operating earnings vs operating marginmany variants of metrics stemming from operating earnings can also be used to compare a given company s profitability with those of its industry peers one of the most important of these metrics is the operating margin which is closely tracked by management and investors from one quarter to the next for an indication of the trend in profitability expressed as a percentage operating margin is calculated by dividing operating earnings by total revenues or as a formula operating margin operating earnings revenue begin aligned text operating margin frac text operating earnings text revenue end aligned operating margin revenueoperating earnings management uses this measure of earnings to gauge the profitability of various business decisions over time external lenders and investors also pay close attention to a company s operating margin because it shows the proportion of revenues that are left over to cover non operating costs such as paying interest on debt obligations highly variable operating margins are a prime indicator of business risk by the same token looking at a company s past operating margins and trends over time is a good way to gauge whether a big increase in earnings is likely to last example of operating earningsassume gadget co had 10 million in revenues in a given quarter 5 million in operating expenses 1 million in interest expense and 2 million in taxes gadget co s operating earnings would be 5 million 10 million in revenue 5 million in operating expenses its operating margin is 50 5 million in operating earnings 10 million in revenue net income would then be derived by subtracting interest expenses and taxes and then netting out any one time or unusual gains and losses from the operating earnings gadget co s net income is therefore 2 million special considerationssometimes a company presents a non gaap adjusted operating earnings figure to account for one off costs that management believes are not part of recurring operating expenses non gaap earnings are an alternative accounting method that varies from the generally accepted accounting principles gaap that u s firms are required to use on financial statements many companies report non gaap earnings in addition to their earnings based on gaap a prime example is expenses stemming from restructuring a type of corporate action taken that involves significantly modifying the debt operations or organization of a company as a way of limiting financial harm and improving the business management may add back these costs to present higher operating earnings on an adjusted basis however critics could point out that restructuring costs should not be classified as one offs if they occur with some regularity | |
what is an operating expense | an operating expense is an expense that a business incurs through its normal business operations often abbreviated as opex operating expenses include rent equipment inventory costs marketing payroll insurance and funds allocated for research and development investopedia crea taylorunderstanding operating expensesoperating expenses are the costs that a company incurs while performing its normal operational activities operational activities are those tasks that must be undertaken from day to day to operate the business and generate revenue operating expenses are different from expenses relating to for example investing in projects and borrowing operating expenses can differ according to what a company does in fact some activities and expenses might be considered operational in one industry but not so in another it s important to understand the distinction due to the tax deductibility of operating expenses some common types of operating expenses include one of the responsibilities that management must contend with is determining how to reduce operating expenses without significantly affecting a firm s ability to compete with its competitors operating expenses are necessary and unavoidable for most businesses some firms successfully reduce operating expenses to gain a competitive advantage and increase earnings however reducing operating expenses can also compromise the integrity and quality of operations finding the right balance can be difficult but can yield significant rewards an income statement tracks the income and expenses of a company over a certain period to provide an image of its profitability income statements typically categorize expenses into six groups cost of goods sold selling general and administrative costs depreciation and amortization other operating expenses interest expenses and income taxes the first four of the above listed costs are usually counted as operating costs interest expenses and income taxes are not operating expenses can be fixed or variable a fixed cost is set for a fixed period of time it doesn t change it typically relates to recurring expenses such as rent interest payments insurance payments and bank fees it isn t affected by the production levels of goods and services a variable cost can change depending on the production and sales levels of products or services a company can better manage its operating expenses when its managers understand the difference between its fixed and variable costs operating vs non operating expensesa non operating expense is an expense incurred by a business that is unrelated to the business s core operations the most common types of non operating expenses are interest charges or other costs of borrowing and losses on the disposal of assets accountants sometimes remove non operating expenses to examine the performance of the business ignoring the effects of financing and other irrelevant issues the internal revenue service irs allows businesses to deduct operating expenses if the business operates to earn profits however the irs and most accounting principles distinguish between operating expenses and capital expenditures 1examplehere s a look at a simple income statement that shows the operating expenses for a company source harvard business school online2opex vs capexabbreviated as capex capital expenditures are purchases that a business makes as an investment capital expenditures include costs related to acquiring maintaining or upgrading tangible and intangible assets tangible business assets include real estate factory equipment computers office furniture and other physical capital assets intangible assets include intellectual property copyrights patents and trademarks the irs treats capital expenses differently than it treats operating expenses according to the irs operating expenses must be ordinary common and accepted in the business trade and necessary helpful and appropriate in the business trade in general businesses are allowed to write off operating expenses for the year in which the expenses were incurred alternatively businesses must capitalize capital expenses costs 1for example if a business spends 100 000 on payroll it can write off the entirety of that expense the year it is incurred but if a business spends 100 000 buying a large piece of factory equipment or a vehicle it must capitalize the expense or write it off over time the irs has guidelines related to how businesses must capitalize assets and there are different classes for different types of assets 1 | |
what is a non operating expense | a non operating expense is a cost that is unrelated to the business s core operations the most common types of non operating expenses are interest charges or other costs of borrowing and losses on the disposal of assets accountants sometimes remove non operating expenses to examine the performance of the business ignoring the effects of financing and other irrelevant issues | |
what are capital expenses | capex includes costs related to acquiring or upgrading capital assets such as property plant and equipment these expenses unlike operating expenses can be capitalized for tax purposes the irs has guidelines related to how businesses must capitalize assets and there are different classes for different types of assets 1 | |
what is the tax treatment for operating expenses | the internal revenue service irs allows businesses to deduct operating expenses if the business operates to earn profits according to the irs operating expenses must be ordinary common and accepted in the business trade and necessary helpful and appropriate in the business trade in general businesses are allowed to write off operating expenses for the year in which the expenses were incurred 1the bottom lineoperating expenses are the expenses that arise from daily core operational activities conducted by a company they are the costs involved in running a business to generate income operating expenses can be fixed or variable typically they re tax deductible as long as a company operates to earn a profit expenses are commonly known and necessary | |
what is the operating expense ratio oer | in real estate the operating expense ratio oer is a measurement of the cost to operate a piece of property compared to the income brought in by the property it is calculated by dividing a property s operating expense minus depreciation by its gross operating income oer is used for comparing the expenses of similar properties an investor should look for red flags such as higher maintenance expenses operating income or utilities that may deter them from purchasing a specific property the ideal oer is between 60 and 80 although the lower it is the better investopedia theresa chiechi | |
what is operating income | operating income is an accounting figure that measures the amount of profit realized from a business s operations after deducting operating expenses such as wages depreciation and cost of goods sold cogs operating income also called income from operations takes a company s gross income which is equivalent to total revenue minus cogs and subtracts all operating expenses a business s operating expenses are costs incurred from normal operating activities and include items such as office supplies and utilities investopedia julie bangunderstanding operating incomeoperating income is a measurement that shows how much of a company s revenue will eventually become profits considering its business operations it s a measurement of what money a company makes only looking at the strictly operational aspect of its company operating income factors in two major types of expenses cost of goods sold and operating expenses cost of goods sold are the expenses directly related to the manufacturing of a good and often include labor raw materials and overhead allocated to items sold operating expenses include the selling administrative and general expenses prior to taxes and interest expenses analyzing operating income is helpful to investors because it doesn t include taxes and other one off items that might skew profit or net income a company that s generating an increasing amount of operating income is seen as favorable because it means that the company s management is generating more revenue while controlling expenses production costs and overhead because operating income deducts less expenses than net income it is usually a higher calculated amount operating income formulas and calculationsoperating income can be calculated in three different ways one approach is top down one approach is a bottom up approach and one leverages cost accounting classifications the formula for operating income using the top down approach is operating income gp oe d a where gp gross profit oe operating expenses d depreciation a amortization begin aligned text operating income text gp text oe text d text a textbf where text gp text gross profit text oe text operating expenses text d text depreciation text a text amortization end aligned operating income gp oe d awhere gp gross profitoe operating expensesd depreciationa amortization gross profit is the net profit earned after the cost of goods sold is subtracted from net revenue operating expenses are the selling administrative and general expenses necessary to operate a business though this does not include interest or taxes because operating expenses do not incorporate allocated costs depreciation and amortization must also be subtracted instead of starting with revenue you can also calculate operating income if you know net income because net income is calculated by subtracting a few items from operating income you can add them back in to arrive at operating income operating income ni ie te where ni net income ie interest expense te tax expense begin aligned text operating income text ni text ie text te textbf where text ni text net income text ie text interest expense text te text tax expense end aligned operating income ni ie tewhere ni net incomeie interest expensete tax expense in this formula you must have a fully calculated income statement as net income is the bottom and last component of the financial statements in this case the company may already be reporting operating income towards the bottom of the report though direct costs and indirect costs are not widely used in financial accounting a company may classify these types of expenses for internal use if a company does so it can find operating income by simply subtracting all of these costs from net revenue as taxes and interest are often not classified as either operating income nr dc ic where nr net revenue dc direct costs ic indirect costs begin aligned text operating income text nr text dc text ic textbf where text nr text net revenue text dc text direct costs text ic text indirect costs end aligned operating income nr dc icwhere nr net revenuedc direct costsic indirect costs in this formula net revenue is used in case there have been product returns or other deductions to make to gross revenue operating income is the amount of income a company generates from its core operations meaning it excludes any income and expenses not directly tied to the core business operating income vs other financial calculations | |
when looking at a company s financial statements revenue is often the highest level of financial reporting gross revenue is the total amount of revenue earned by a company for a given period while net revenue is the total amount of revenue less any discounts returns or deductions to make from the total that was sold | while revenue does not incorporate any expenses operating income does in fact it incorporates almost every expense of a company revenue may demonstrate how successful a product is selling but operating income is more useful in demonstrating how successful a company is at being efficient with how it spends money to incur that revenue it s important to note that operating income is different than net income operating income includes expenses such as costs of goods sold and operating expenses however operating income does not include items such as other income non operating income and non operating expenses instead those figures are included in the net income calculation in almost all cases operating income will be higher than net income because net income often deducts more expenses than operating income for this reason net income is often the last line reported on an income statement while operating income is usually found a few lines above it operating income is similar to a company s earnings before interest and taxes ebit it is also referred to as the operating profit or recurring profit both measurements calculate the amount of money a company earned less a few noncontrollable costs technically ebit may include other operating expenses outside of interest and taxes but for most companies these two calculations will be the same ebitda on the other hand will differ from operating income as operating income deducts depreciation and amortization expense ebitda is calculated without incorporating either if a company does not have interest expenses tax expenses or other non operational costs it is possible for a company s operating income to be the same as its net income example of operating incomethe image below represents apple inc s income statement for the three months ending june 25 2022 it also represents the nine month period for the company through the end of q3 on its income statement apple reported 82 959 billion of product and service revenue up very slightly from the prior year however looking further down its income statement the company s operating income for the three month period was 23 076 billion less than the 24 126 billion from the year before the reason for this is the increase in expenses first the company s cost of goods sold increased from last year to this year second the company s operating expenses also increased both research and development as well as selling general and administrative expenses increased the company spent 11 129 billion on operating expenses the year prior now it had reported operating expenses of almost 13 billion last the company is reporting a very material increase in provision for income taxes as apple inc estimated an additional 1 billion of expenses from what had been incurred one year ago 1 because this expense is not directly tied to operational functions of the company this increase has no bearing on operational income though it does factor into net income | |
is operating income the same as profits | not exactly operating income is what is left over after a company subtracts the cost of goods sold cogs and other operating expenses from the sales revenues it receives however it does not take into consideration taxes interest or financing charges can a company have a high operating income but lose money while a good operating income is often indicative of profitability there may be cases when a company earns money from operations but must spend more on interest and taxes this could be due to a one time charge poor financial decisions made by the company or an increasing interest rate environment that impacts outstanding debts alternatively a company may earn a great deal of interest income which would not show up as operating income | |
what is non operating income | in contrast to operating income non operating income is the portion of an organization s income that is derived from activities not related to its core business operations it can include items such as dividend income interest gains or losses from investments as well as those incurred in foreign exchange and asset write downs | |
where would i find a company s operating income | operating income is recorded on the income statement and can be found toward the bottom of the statement as its own line item it should appear next to non operating income helping investors to distinguish between the two and recognize which income came from what sources the bottom linecompanies may be more interested in knowing their operating income instead of their net income as operating income only incorporates the costs of directly operating the company operating income can be calculated several different ways but it is always found towards the bottom of a company s income statement operating income is generally defined as the amount of money left over to pay for financial costs such as interest or taxes | |
what is operating income before depreciation and amortization oibda | operating income before depreciation and amortization oibda is a measure of financial performance used by companies to show profitability in their core business activities oibda excludes the effects of capital spending on fixed assets such as equipment and the interest expense of carrying debt sometimes oibda may not include changes in accounting principles that are not indicative of core operating results income from discontinued operations and the earnings and losses of subsidiaries understanding operating income before depreciation and amortization oibda operating income before depreciation and amortization oibda attempts to show how much income a company is earning for its core business by analyzing a company s oibda we can see how well a company generates revenue from sales while managing its production and operating expenses oibda is a non gaap financial measure meaning it s not a regulatory requirement when companies report their financial statements regulatory agencies such as the securities and exchange commission sec mandate that companies report their financial performance in a standardized format to help investors and creditors compare companies more effectively however oibda is still a useful metric since it can help investors understand how well a company generates income from its core production and manufacturing business below are the components that are often used in calculating oibda operating income is the income that a company earns from its core business operating income is the result of subtracting operating expenses from gross profit gross profit is a company s revenue minus its cost of goods sold cogs cost of goods sold represents the cost of inventory and supplies needed to produce the goods being sold that generate revenue while gross profit shows how much profit a company earns from its production line operating income is more inclusive operating income includes operating expenses for running the company in addition to cogs | |
when companies purchase an asset such as a piece of machinery it can be quite expensive the cost of the asset can be used to reduce a company s taxable income in other words net income is reduced by the cost of the asset for tax purposes thus lowering the taxes paid on the company s profit | instead of reporting the total cost of the asset in the year that it was purchased companies are allowed to spread the cost of that asset each year over the estimated useful life of the asset this process of expensing the asset over the years is called depreciation and is helpful since it allows companies to earn profit from the asset while expensing only a portion of it each year amortization is the same practice as depreciation except that amortization is used for intangible assets such as a patent while depreciation is used for tangible assets such as machinery when calculating oibda depreciation and amortization are added back into operating income since they are typically subtracted from gross profit to arrive at operating income interest and taxes are expense line items found on the income statement many companies that purchase fixed assets such as a building must borrow the money to finance the purchase as a result the company must pay an interest expense each accounting period which represents the interest rate applied to the debt by the lender taxes are also listed as a separate line item on the income statement showing the tax expense that the company paid based on the applicable tax rate and profit generated interest and taxes are usually listed after operating income meaning they are not included in operating expenses as a result these two expenses would not normally be included in the oibda calculation however some companies report interest and tax expenses higher on the income statement and are reflected in operating income and therefore must be added back into operating income to arrive at oibda formula and calculation of oibdathe formula for calculating operating income before depreciation and amortization oibda is shown below oibda oi d a tax interest where oi operating income d depreciation a amoritization begin aligned text oibda text oi text d text a text tax text interest textbf where text oi text operating income text d text depreciation text a text amoritization end aligned oibda oi d a tax interestwhere oi operating incomed depreciationa amoritization please note that some companies may embed depreciation and amortization expense within their cogs or selling general and administrative expense sg a in other words there may not be a separate line item for depreciation and amortization in this case the company s cash flow statement must be used to find the line item when calculating cash flow companies must add non cash expenses such as d a to net income to arrive at the cash flow for the period oibda vs ebitdaoibda and ebitda or earnings before interest taxes depreciation and amortization are similar but use different income numbers as their starting points the oibda calculation begins with operating income while ebitda begins with net income which represents the profit for the accounting period unlike ebitda oibda does not incorporate non operating income or one time charges one time items ultimately add or deduct from a company s profit or earnings but are not included in oibda this can be seen as an advantage for comparison purposes since non operating income usually doesn t reoccur year after year its separation from operating income ensures that the calculation only reflects the income earned from core operations example of oibdabelow is the income statement for walmart inc for the company s fiscal year ending jan 31 2021 via the company s 10 k report issued on march 19 2021 1as a result we must refer to walmart s cash flow statement for the same period which is shown below walmart s oibda can also be calculated for 2020 and 2019 to compare with 2021 s oibda to get a better sense of whether 2021 was a good year or not walmart s 2021 oibda of 33 70 billion was more than 2 billion higher than 2020 however 2021 s oibda was approximately 1 billion higher than 2019 we can see that walmart is increasing its income from its core business operations since oibda in 2021 was much better than 2020 and also beat 2019 s oibda however 2021 s oibda was nearly 1 billion higher than 2019 in part due to a higher depreciation expense for 2021 of 11 152 billion versus 10 678 perhaps the company purchased new assets in 2021 which led to a higher depreciation expense | |
what is an operating lease | an operating lease is a contract that allows for an asset s use but does not convey ownership rights of the asset these leases allow businesses to use the asset without incurring the high expenses involved in purchasing it the business that leases the asset is called the lessee and the business that loans it under a lease is called the lessor the responsibilities of each party in the agreement are spelled out in the lease contract and documents but generally the lessee must maintain the asset to ensure it remains in operational condition less any normal wear and tear | |
how operating leases work | historically operating leases enabled american firms to keep billions of dollars of assets and liabilities from being recorded on their balance sheets thereby keeping their debt to equity ratios low however this changed in 2016 with the release of accounting standards update 2016 02 leases topic 842 and amendments in the few years following 1operating leases are assets rented by a business where ownership of the asset is not transferred when the rental period is complete typically assets rented under operating leases include real estate aircraft and equipment with long useful life spans such as vehicles office equipment or industry specific machinery essentially an operating lease is a contract for a company to use an asset and return it in a similar condition to the lessor this agreement is beneficial for the lessee particularly when it has expensive equipment or other assets that need to be replaced regularly advantages and disadvantages of an operating leaseno ownershiprenting may be cheapershort termno equityfinancing costsmight pay more than market valuecontinuous terms renegotiationexample of an operating leasea restaurant needs power to ensure it can operate during outages and not have food spoil when refrigeration systems are offline power keeps a restaurant from losing business and costly supplies a restaurant owner should ensure they have a generator for this reason but they might need a much bigger and more expensive one they ll need to power freezers refrigerators ovens heating lamps lights air conditioning water heaters computer systems and more large generators can cost tens of thousands of dollars so the owner might choose to lease one the owner would make rental payments to an equipment rental service and account for it as an asset and a liability on their balance sheet because they ll likely need it for more than one year accounting for an operating leaseoperating lease accounting changed in 2016 when the federal accounting standards board released asc topic 842 leases the new standard provided guidance when accounting for leases where the lease and the corresponding asset value would be required to be reported on the balance sheet however leases for less than 12 months can be recognized as an expense using the straight line basis method 2 | |
when a lease of more than 12 months is initiated the lessee must account for it as a lease liability and an asset right of use on the balance sheet the intent behind the change is to reduce the ability of organizations to manipulate the balance sheet and create a more faithful representation of a business s rights and obligations 3 | this new standard does not apply to 4operating lease vs finance leaseoperating and finance leases are similar for accounting purposes they are both treated as a right of use asset and a lease liability they are recorded on the company s balance sheet as a result they can affect a company s financial ratios such as debt to equity return on assets or solvency if companies use a significant amount of leased assets 5 however there are several differences operating lease characteristics include 6finance lease characteristics include 6 | |
what is the meaning of operating lease | an operating lease is like renting a business can lease assets it needs to operate | |
what is the difference between an operating lease and a finance lease | a finance lease transfers the asset and any risk or return to the lessee this means that ownership is transferred in a financial lease to the entity that leases the asset in an operating lease the ownership remains with the lessor the entity that leased the asset to the lessee | |
what are operating leases used for | operating leases allow companies greater flexibility to upgrade assets like equipment which reduces the risk of obsolescence there is no ownership risk and payments are considered to be operating expenses and tax deductible finally the risks and benefits remain with the lessor as the lessee is only liable for the maintenance costs the bottom lineoperating leases are leases a business might use to rent assets rather than buy them outright many small and medium sized businesses cannot afford some of the expensive assets they need to operate so it makes sense for them and it s cheaper to rent them businesses must account for operating leases as assets and liabilities for assets leased for more than 12 months this standard makes their balance sheet a more realistic representation of the company s worth and obligations regarding leases | |
what is operating leverage | operating leverage is a cost accounting formula a financial ratio that measures the degree to which a firm or project can increase operating income by increasing revenue a business that generates sales with a high gross margin and low variable costs has high operating leverage investopedia nono floresunderstanding operating leveragethe higher the degree of operating leverage the greater the potential danger from forecasting risk in which a relatively small error in forecasting sales can be magnified into large errors in cash flow projections degree of operating leverage contribution margin profit text degree of operating leverage frac text contribution margin text profit degree of operating leverage profitcontribution margin this can be restated as degree of operating leverage q c m q c m fixed operating costs where q unit quantity c m contribution margin price variable cost per unit begin aligned text degree of operating leverage frac q cm q cm text fixed operating costs textbf where q text unit quantity cm text contribution margin price variable cost per unit end aligned degree of operating leverage q cm fixed operating costsq cm where q unit quantitycm contribution margin price variable cost per unit the operating leverage formula is used to calculate a company s break even point and help set appropriate selling prices to cover all costs and generate a profit the formula can reveal how well a company uses its fixed cost items such as its warehouse machinery and equipment to generate profits the more profit a company can squeeze out of the same amount of fixed assets the higher its operating leverage one conclusion companies can learn from examining operating leverage is that firms that minimize fixed costs can increase their profits without making any changes to the selling price contribution margin or the number of units they sell example of operating leveragefor example company a sells 500 000 products for a unit price of 6 each the company s fixed costs are 800 000 it costs 0 05 in variable costs per unit to make each product calculate company a s degree of operating leverage as follows 500 000 6 00 0 05 500 000 6 00 0 05 800 000 2 975 000 2 175 000 1 37 or 137 begin aligned frac 500 000 left 6 00 0 05 right 500 000 left 6 00 0 05 right 800 000 frac 2 975 000 2 175 000 1 37 text or 137 end aligned 500 000 6 00 0 05 800 000500 000 6 00 0 05 2 175 000 2 975 000 1 37 or 137 a 10 revenue increase should result in a 13 7 increase in operating income 10 x 1 37 13 7 high and low operating leverageit is important to compare operating leverage between companies in the same industry as some industries have higher fixed costs than others the concept of a high or low ratio is then more clearly defined most of a company s costs are fixed costs that recur each month such as rent regardless of sales volume as long as a business earns a substantial profit on each sale and sustains adequate sales volume fixed costs are covered and profits are earned other company costs are variable costs that are only incurred when sales occur this includes labor to assemble products and the cost of raw materials used to make products some companies earn less profit on each sale but can have a lower sales volume and still generate enough to cover fixed costs one concept positively linked to operating leverage is capacity utilization which is how much the company uses its resources to generate revenues increasing utilization infers increased production and sales thus variable costs should rise if fixed costs remain the same a firm will have high operating leverage while operating at a higher capacity for example a software business has greater fixed costs in developers salaries and lower variable costs in software sales as such the company has high operating leverage in contrast a computer consulting firm charges its clients hourly and doesn t need expensive office space because its consultants work in clients offices this results in variable consultant wages and low fixed operating costs the business thus has low operating leverage most of microsoft s costs are fixed such as expenses for upfront development and marketing with each dollar in sales earned beyond the break even point the company makes a profit but microsoft has high operating leverage conversely walmart retail stores have low fixed costs and large variable costs especially for merchandise because walmart sells a huge volume of items and pays upfront for each unit it sells its cost of goods sold increases as sales increase because of this walmart stores have low operating leverage | |
what does operating leverage tell you | the operating leverage formula is used to calculate a company s break even point and help set appropriate selling prices to cover all costs and generate a profit this can reveal how well a company uses its fixed cost items such as its warehouse machinery and equipment to generate profits the more profit a company can squeeze out of the same amount of fixed assets the higher its operating leverage | |
what is an operating loss ol | an operating loss occurs when a company s operating expenses exceed gross profits or revenues in the case of a service oriented company a company s operating profit is its profit before interest and taxes interest and taxes are not considered operating expenses in the way that cost of goods sold selling general and administrative expenses are often companies generate enough revenue to cover the operating expenses and make an operating profit an operating loss does not consider the effects of interest income interest expense extraordinary gains or losses or income or losses from equity investments or taxes these items are below the line meaning they are added or subtracted after the operating loss or income if positive to arrive at net income if there is an operating loss there is usually a net income loss unless an extraordinary gain e g sale of an asset was recorded during the accounting period understanding operating lossesan operating loss indicates that a company s core operations are not profitable and that changes need to be made to increase revenues decrease costs or both the immediate solution is typically to cut back on expenses as this is within the control of company management layoffs office or plant closings or reductions in marketing spending are ways to reduce expenses an operating loss is expected for start up companies that mostly incur high expenses with little or no revenues as they attempt to grow quickly in most other situations if sustained an operating loss is a sign of deteriorating fundamentals of a company s products or services however that s not necessarily the case if a company is spending more money in the short term to hire additional employees conduct a fresh sales and marketing campaign or lease extra office space in anticipation of expanded future business in such a scenario a company may be hit with a few or several quarters of operating losses until the bump up of the expenditures declines and the benefits of the added spending manifest in the top line real world example of operating lossfor a company that manufactures products gross profit is sales less the cost of goods sold cogs in 2009 the year that the great recession took hold huntsman corporation recorded an operating loss of over 71 million that year gross profit was 1 068 million while operating expenses composed of selling general and administration sg a research and development r d restructuring impairment and plant closing costs totaled 1 139 million leaving the chemical maker with an operating loss the last expense line item was 152 million in charges such expenses in most cases are considered non recurring which means that a normalized operating income loss number would exclude the charge instead of the operating loss an adjusted result would be an operating profit of 81 million | |
what is operating margin | the operating margin measures how much profit a company makes on a dollar of sales after paying for variable costs of production such as wages and raw materials but before paying interest or tax it is calculated by dividing a company s operating income by its net sales higher ratios are generally better illustrating the company is efficient in its operations and is good at turning sales into profits investopedia julie bangunderstanding the operating margina company s operating margin sometimes referred to as return on sales ros is a good indicator of how well it is being managed and how efficient it is at generating profits from sales it shows the proportion of revenues that are available to cover non operating costs such as paying interest which is why investors and lenders pay close attention to it highly variable operating margins are a prime indicator of business risk by the same token looking at a company s past operating margins is a good way to gauge whether a company s performance has been getting better the operating margin can improve through better management controls more efficient use of resources improved pricing and more effective marketing in its essence the operating margin is how much profit a company makes from its core business in relation to its total revenues this allows investors to see if a company is generating income primarily from its core operations or from other means such as investing calculating the operating marginthe formula for operating margin is operating margin operating earnings revenue begin aligned text operating margin frac text operating earnings text revenue end aligned operating margin revenueoperating earnings | |
when calculating operating margin the numerator uses a firm s earnings before interest and taxes ebit ebit or operating earnings is calculated simply as revenue minus cost of goods sold cogs and the regular selling general and administrative costs of running a business excluding interest and taxes | for example if a company had revenues of 2 million cogs of 700 000 and administrative expenses of 500 000 its operating earnings would be 2 million 700 000 500 000 800 000 its operating margin would then be 800 000 2 million 40 if the company was able to negotiate better prices with its suppliers reducing its cogs to 500 000 then it would see an improvement in its operating margin to 50 limitations of the operating marginthe operating margin should only be used to compare companies that operate in the same industry and ideally have similar business models and annual sales companies in different industries with wildly different business models have very different operating margins so comparing them would be meaningless it would not be an apples to apples comparison to make it easier to compare profitability between companies and industries many analysts use a profitability ratio that eliminates the effects of financing accounting and tax policies earnings before interest taxes depreciation and amortization ebitda for example by adding back depreciation the operating margins of big manufacturing firms and heavy industrial companies are more comparable ebitda is sometimes used as a proxy for operating cash flow because it excludes non cash expenses such as depreciation however ebitda does not equal cash flow this is because it does not adjust for any increase in working capital or account for capital expenditure that is needed to support production and maintain a company s asset base as operating cash flow does other profit marginsby comparing ebit to sales operating profit margins show how successful a company s management has been at generating income from the operation of the business there are several other margin calculations that businesses and analysts can employ to get slightly different insights into a firm s profitability the gross margin tells us how much profit a company makes on its cost of sales or cogs in other words it indicates how efficiently management uses labor and supplies in the production process the net margin considers the net profits generated from all segments of a business accounting for all costs and accounting items incurred including taxes and depreciation in other words this ratio compares net income with sales it comes as close as possible to summing up in a single figure how effectively the managers are running a business | |
why is operating margin important | the operating margin is an important measure of a company s overall profitability from operations it is the ratio of operating profits to revenues for a company or business segment expressed as a percentage the operating margin shows how much earnings from operations is generated from every 1 in sales after accounting for the direct costs involved in earning those revenues larger margins mean that more of every dollar in sales is kept as profit | |
when a company s operating margin exceeds the average for its industry it is said to have a competitive advantage meaning it is more successful than other companies that have similar operations while the average margin for different industries varies widely businesses can gain a competitive advantage in general by increasing sales or reducing expenses or both | boosting sales however often involves spending more money to do so which equals greater costs cutting too many costs can also lead to undesirable outcomes including losing skilled workers shifting to inferior materials or other losses in quality cutting advertising budgets may also harm sales to reduce the cost of production without sacrificing quality the best option for many businesses is expansion economies of scale refer to the idea that larger companies tend to be more profitable a large business s increased level of production means that the cost of each item is reduced in several ways for example raw materials purchased in bulk are often discounted by wholesalers | |
how is operating margin different from other profit margin measures | operating margin takes into account all operating costs but excludes any non operating costs net profit margin takes into account all costs involved in a sale making it the most comprehensive and conservative measure of profitability gross margin on the other hand simply looks at the costs of goods sold cogs and ignores things such as overhead fixed costs interest expenses and taxes | |
what are some high and low profit margin industries | high profit margin sectors are typically those where competitive pressures allow companies to generate sales that are produced without having to spend much on development marketing overheads and production initially start up companies may make losses until they establish themselves for example software or gaming companies may invest initially while developing a particular software game and cash in big later by simply selling millions of copies with very few expenses operations intensive businesses such as transportation which may have to deal with fluctuating fuel prices drivers perks and retention and vehicle maintenance usually have lower profit margins automobiles also have low profit margins as profits and sales are limited by intense competition uncertain consumer demand and high operational expenses involved in developing dealership networks and logistics | |
what is operating profit | a company s operating profit is its total earnings from its core business functions for a given period put simply operating profit is a company s net income from its core operations after accounting for operating expenses operating profit excludes the deduction of interest and taxes as well as any profits earned from ancillary investments such as earnings from other businesses in which a company has a part interest an operating loss occurs when core business income ends up being lower than expenses investopedia sydney saporitoformula and calculation of operating profitthe formula used to calculate operating profit is | |
where | gross profit revenue cost of goods sold cogs operating profit is also referred to colloquially as earnings before interest and tax ebit however ebit can include non operating revenue which is not included in operating profit if a company doesn t have non operating revenue ebit and operating profit will be the same figure understanding operating profitoperating profit serves as a highly accurate indicator of a business s health because it removes all extraneous factors from the calculation all expenses that are necessary to keep the business running are included which is why operating profit takes into account asset related depreciation and amortization accounting tools that result from a firm s operations companies can choose to present their operating profit figures in place of their net profit figures as the net profit of a company contains the effects of taxes and interest payments if a company has a particularly high debt load the operating profit may present the company s financial situation more positively than the net profit reflects while positive operating profit may express the overall health of a business it does not guarantee future profitability case in point a company with a high debt load may show a positive operating profit while simultaneously experiencing net losses in addition large but extraneous costs are not represented which may also show a company with a negative net profit having a positive operating profit special considerationsrevenue created through the sale of assets is not included in the operating profit figure except for any items created for the explicit purpose of being sold as part of the core business in addition interest earned from cash such as checking or money market accounts is not included while the removal of production costs from overall operating revenue along with any costs associated with depreciation and amortization is permitted when determining the operating profit the calculation does not account for any liabilities that must be met this is the case even if those obligations are directly tied to the company s ability to maintain normal business operations operating income does not include investment income generated through a partial stake in another company even if the investment income is tied directly to the core business operations of the second company the sale of assets such as real estate and production equipment is also not included as these sales are not a part of the core operations of the business operating profit vs other profit measuresoperating profit is one metric that is used to determine a company s profitability from its core operations other metrics may seem the same but shouldn t be confused we ve highlighted some of the most common ones below | |
don t confuse operating profit with gross profit as the two are very different concepts gross profit is the total revenue of a company minus the expenses directly related to the production of goods for sale such as the cost of goods sold companies report their gross profit on their income statement you can calculate gross profit as follows | derived from gross profit operating profit reflects the residual income that remains after accounting for all the costs of doing business remember that operating profit is an accounting metric for the stakeholders who care about the operational profitability of the company earnings before interest taxes depreciation and amortization ebitda on the other hand is a cash focused metric for stakeholders who care about the cash flow of the business ebitda takes operating profit and adds back interest depreciation and amortization here s how it s calculated net profit is the profit remaining after all costs incurred in the period have been subtracted from revenue generated from sales expenses that factor into the calculation of net income but not operating profit include payments on debts interest on loans and one time payments for unusual events such as lawsuits additional income not counted as revenue is also considered in the calculation of net income and includes interest earned on investments and funds from the sale of assets not associated with primary operations example of operating profitwalmart wmt reported operating income of 27 01 billion for its fiscal year 2024 total revenues net sales as well as membership and other income were 648 12 billion 1 these revenues came from sales across walmart s global umbrella of physical stores including sam s club and its e commerce businesses 2meanwhile the cost of sales or cogs and operating selling general and administrative expenses totaled 490 14 billion and 130 97 billion respectively 1 | |
what does operating profit tell you | operating profit is a useful and accurate indicator of a business s health because it removes any irrelevant factor from the calculation operating profit only takes into account those expenses that are necessary to keep the business running this includes asset related depreciation and amortization which result from a firm s operations operating profit is also referred to as operating income | |
how do you calculate operating profit | operating profit is calculated by taking revenue and then subtracting the cost of goods sold operating expenses depreciation and amortization | |
how do you find the operating profit margin | the operating profit or operating income can be found on the income statement or calculated as it is the profit left after deducting the costs of running the business operating profit margin is calculated by dividing operating income by revenue | |
what is excluded from the operating profit | revenue created through the sale of assets is not included in the operating profit figure except for any items created for the explicit purpose of being sold as part of the core business in addition interest earned from cash such as checking or money market accounts is not included nor does it account for any debt obligations that must be met finally it does not include investment income generated through a partial stake in another company the bottom lineoperating profit looks at a company s earnings generated through normal business operations analyzing operating profit which can be found on the income statement is useful because it excludes accounting items such as one time charges interest and taxes that may skew a company s profit in a given year these items are accounted for instead in a company s net profit or bottom line | |
what is an operating ratio | the term operating ratio refers to the efficiency of a company s management by comparing the total operating expense opex of a company to net sales the operating ratio shows how efficient a company s management is at keeping costs low while generating revenue or sales the smaller the ratio the more efficient the company is at generating revenue vs total expenses investopedia eliana rodgersformula and calculation of operating ratiothe formula used to calculate the operating ratio is o p e r a t i n g r a t i o o p e r a t i n g e x p e n s e s c o s t o f g o o d s s o l d n e t s a l e s operating ratio frac operating expenses cost of goods sold net sales operatingratio netsalesoperatingexpenses costofgoodssold | |
what is operating revenue | operating revenue is the revenue that a company generates from its primary business activities for example a retailer produces its operating revenue through merchandise sales a physician derives their operating revenue from the medical services that they provide what constitutes operating revenue varies based on the business or the industry investopedia theresa chiechiunderstanding operating revenuedistinguishing operating revenue from total revenue is important because it provides valuable information about the productivity and profitability of a company s primary business operations despite the fact that operating revenue is recorded separately on financial statements some firms may attempt to mask decreases in operating revenue by combining it with non operating revenue understanding and identifying the sources of revenue is helpful in assessing the health of a firm and its operations operating revenue vs non operating revenuenon operating revenue is revenue generated by activities outside of a company s primary operations this type of revenue tends to be infrequent and oftentimes unusual examples of non operating income include interest income gains from the sale of assets lawsuit proceeds and revenues from other sources not connected to operations for example a private university may classify tuition received as operating revenue whereas gifts from alumni are considered non operating revenue because they are not expected nor are they part of ordinary university operations in this example the university s income statement lists operating revenue and profit from operations first then it posts non operating revenue and profit such as revenue received from gifts and legacy donations this presentation of information informs those reviewing the company s financial records that the gift is not an ordinary part of the university s business it is important to distinguish the difference because non operating revenue can change drastically from year to year special considerationsnon operating revenue and income do not produce cash inflows that are consistent from one year to the next which is another reason why the activity is separately identified in the income statement for a company to fund company operations the business must generate operating revenue firms that drive operating revenue can fund the business regularly without the need to seek additional financing and these companies can operate with a lower cash balance for example a company may sell a fixed asset such as a building in the current year if the building is sold at a gain the gain will be treated as non operating revenue in the year it was sold this revenue is not expected as a normal course of doing business and the one time revenue should not be used to assess the success of the company s primary operations year over year for a successful company operating revenue and income are the primary sources of earnings per share eps this ratio is a key statistic for evaluating a firm s stock price eps is defined as earnings available to common shareholders divided by common shares outstanding a well managed business can grow operating revenue and income by finding more customers and moving into new markets that generate higher earnings as eps increases many investors and analysts consider the stock to be more valuable and the stock price increases | |
what is operation twist | operation twist is a federal reserve fed monetary policy initiative used in the past to lower long term interest rates to further stimulate the u s economy when traditional monetary tools were lacking via the timed purchase and sale of u s treasuries of different maturities the term gets its name from the simultaneous buying of long term bonds and selling short term bonds suggests a twisting of the yield curve and creating less curvature in the rates term structure understanding operation twistthe name operation twist was given by the mainstream media due to the visual effect that the monetary policy action was expected to have on the shape of the yield curve if you visualize a linear upward sloping yield curve this monetary action effectively twists the ends of the yield curve hence the name operation twist to put it another way the yield curve twists when short term yields go up and long term interest rates drop at the same time the original operation twist came about in 1961 when the federal open market committee fomc sought to strengthen the u s dollar usd and stimulate inflows of cash into the economy at this time the country was still recovering from a recession following the end of the korean war in order to promote spending in the economy the yield curve was flattened by selling short term government debt in the markets and using the proceeds from the sale to purchase long term government debt 1 the operation describes a form of monetary policy where the fed buys and sells short term and long term bonds depending on their objective however unlike quantitative easing qe operation twist does not expand the fed s balance sheet making it a less aggressive form of easing market turmoil in early 2021 has fueled speculation that the fed could use operation twist for the first time in nearly a decade special considerationsremember there is an inverse relationship between bond prices and yield when prices go down in value the yield increases and vice versa the fed s purchasing activity of long term debt drives up the price of the securities and in turn decreases the yield when long term yields fall faster than short term rates in the market the yield curve flattens to reflect the smaller spread between the long term and short term rates also note that selling short term bonds would decrease the price and hence increase the rates however the short end of the yield curve based on short term interest rates is determined by expectations of the federal reserve policy rising when the fed is expected to raise rates and falling when interest rates are expected to be cut since operation twist involves the fed leaving short term rates unchanged only the long term rates will be impacted by the buy and sell activity conducted in the markets this would cause long term yields to decrease at a higher rate than short term yields operation twist mechanismin 2011 the fed could not reduce short term rates any further since the rates were already at zero 2 the alternative then was to lower long term interest rates to achieve this the fed sold short term treasury securities and bought long term treasuries which pressured the long term bond yields downward thereby boosting the economy 1as short term treasury bills t bills and notes matured the fed would use the proceeds to buy longer term treasury notes t notes and bonds the effect on short term interest rates was minimal as the fed had committed to keeping short term interest rates near zero for the next couple of years 1during this time the yield on 2 year bonds was close to zero and the yield on 10 year t notes the benchmark bond for interest rates on all fixed rate loans was only about 1 95 3a fall in interest rates reduces the cost of borrowing for businesses and individuals when these entities have access to loans at low interest rates spending in the economy increases and unemployment falls as businesses can affordably secure capital to expand and finance their projects | |
what is operational efficiency | operational efficiency is primarily a metric that measures the efficiency of profit earned as a function of operating costs the greater the operational efficiency the more profitable a firm or investment is this is because the entity is able to generate greater income or returns for the same or lower cost than an alternative in financial markets operational efficiency occurs when transaction costs and fees are reduced an operationally efficient market may also be known as an internally efficient market understanding operational efficiencyoperational efficiency in the investment markets is typically centered around transaction costs associated with investments operational efficiency in the investment markets can be compared to general business practices for operational efficiency in production operationally efficient transactions are those that are exchanged with the highest margin meaning an investor pays the lowest fee to earn the highest profit similarly companies seek to earn the highest gross margin profit from their products by manufacturing goods at the lowest cost in nearly all cases operational efficiency can be improved by economies of scale in the investment markets this can mean buying more shares of an investment at a fixed trading cost to reduce the fee per share a market is reported to be operationally efficient when conditions exist allowing participants to execute transactions and receive services at a price that equates fairly to the actual costs required to provide them operationally efficient markets are typically a byproduct of competition operationally efficient markets may also be influenced by regulation that works to cap fees in order to protect investors against exorbitant costs operationally efficient markets can help to improve the overall efficiency of investment portfolios greater operational efficiency in the investment markets means capital can be allocated without excessive frictional costs that reduce the risk reward profile of an investment portfolio investment funds are also analyzed by their comprehensive operational efficiency a fund s expense ratio is one metric for determining operational efficiency a number of factors influence the expense ratio of a fund transaction costs management fees and administrative expenses comparatively funds with a lower expense ratio are generally considered to be more operationally efficient productivity vs efficiencyproductivity serves as a measurement of output normally expressed as some units per amount of time for example 100 units per hour efficiency in production most often relates to the costs per unit of production rather than just the number of units produced productivity versus efficiency can also involve analysis of economies of scale entities seek to optimize production levels in order to achieve efficient economies of scale which then helps to lower per unit costs and increase per unit returns examples of investment market operational efficiencyfunds with greater assets under management aum can obtain greater operational efficiency because of the higher number of shares transacted per trade generally passive investment funds are typically known to have greater operational efficiency than active funds based on their expense ratios passive funds offer targeted market exposure through index replication large funds have the advantage of economies of scale in trading for passive funds following the holdings of an index also incurs lower transaction costs in other areas of the market certain structural or regulatory changes can make participation more operationally efficient in 2000 the commodity futures trading commission cftc passed a resolution allowing money market funds to be considered eligible margin requirements prior to this only cash was eligible this minor change reduced unnecessary costs of trading in and out of money market funds making the futures markets more operationally efficient 1financial regulators have also imposed an 8 5 sales charge cap on mutual fund commissions 2 this cap helps to improve operational trading efficiency and investment profits for individual investors | |
what is operational risk | operational risk summarizes the uncertainties and hazards a company faces when it attempts to do its day to day business activities within a given field or industry a type of business risk it can result from breakdowns in internal procedures people and systems as opposed to problems incurred from external forces such as political or economic events or inherent to the entire market or market segment known as systematic risk operational risk can also be classified as a variety of unsystematic risk which is unique to a specific company or industry | |
what is an operating target | an operating target is a specific number for an interest rate or another financial metric that a central bank sets in order to guide its monetary policy once the operating target is set the central bank executes its policies which are designed to loosen or tighten the supply of money in the economy in order to achieve and maintain the target understanding an operating targetcentral banks such as the u s federal reserve are charged with goals that relate to the overall economic performance of a nation however they lack the ability to directly control factors such as consumer prices or gross domestic product so they choose intermediate targets to monitor these targets are economic variables that can be directly impacted by monetary policy and are either causally linked or at least correlated with a nation s overall economic performance the goals that a central bank chooses to focus on are called its operating targets a central bank uses an operating target the same way a driver uses the speedometer in a car a driver wants to get from point a to point b at a speed that balances timeliness with safety the driver cannot directly control the speed of the car only the position of the throttle which directs fuel to the engine nor can the driver easily observe the car s speed except by looking out the window and guessing at how fast objects on the side of the road seem to be passing so cars have a speedometer so that the driver can gauge how far to depress the gas pedal the speedometer measures the rotational speed or the driveshaft or the wheels of the car which should be closely correlated to the car s ground speed and helpfully displays the car s estimated speed on a clearly visible gauge by viewing this gauge and adjusting the position of the throttle a drive can choose and maintain an appropriate speed similarly a central bank chooses an operating target that helps it gauge how much money and credit to add to the banking system to achieve and maintain its policy goals too little and debt deflation might slow the economy down too much and an overheated economy runaway hyperinflation or a crack up boom could result the central bank faces a similar problem as the driver it cannot directly control or even readily observe factors like inflation or gdp growth in real time instead it chooses an economic variable or operating target that it can observe that it can directly influence with its policies and that is closely connected to the ultimate measures of economic performance that it wants to influence the u s federal reserve uses operating targets in its day to day and long term implementation of monetary policy the federal reserve board frb decides on the value of the operational target at each of its regular meetings the board then uses monetary policy tools primarily permanent open market operations to reach this target much of the operational target aims at adjustments to the federal funds rate a short term interbank interest rate its decisions are posted on the federal reserve website 1the fed adjusts its desired target rate for the fed funds rate based on its estimates of the current and future economic conditions and then buys or sells government bonds to increase or decrease the supply of bank reserves available for overnight lending between banks it does so with the expectation that this will in turn influence the amount of bank lending in the economy and thus overall economic performance the fed also uses public announcements about its operating target as a further tool of monetary policy to communicate forward guidance regarding its likely future target rates in order to manage market expectations | |
what is operations management | operations management om is the administration of business practices to create the highest level of efficiency possible within an organization it is concerned with converting materials and labor into goods and services as efficiently as possible to maximize the profit of an organization operations management teams attempt to balance costs with revenue to achieve the highest net operating profit possible katie kerpel investopediaunderstanding operations managementoperations management involves utilizing resources from staff materials equipment and technology operations managers acquire develop and deliver goods to clients based on client needs and the company s abilities operations management handles various strategic issues including determining the size of manufacturing plants and project management methods and implementing the structure of information technology networks other operational issues include the management of inventory levels including work in process levels and raw materials acquisition quality control materials handling and maintenance policies operations management entails studying the use of raw materials and ensuring that minimal waste occurs operations managers use numerous formulas such as the economic order quantity formula to determine when and how large an inventory order to process and how much inventory to hold on hand the combination of understanding and coordinating the work of a company is central to becoming a successful operations manager operations and supply chain management oscm a critical function of operations management relates to the management of inventory through the supply chain 1 this process is known as operations and supply chain management oscm to be an effective operations management professional one must be able to understand the processes that are essential to what a company does and get them to flow and work together seamlessly the coordination involved in setting up business processes in an efficient way requires a solid understanding of logistics an operations management professional understands local and global trends customer demand and available resources for production operations management approaches the acquisition of materials and the use of labor in a timely cost effective manner to deliver customer expectations inventory levels are monitored to ensure that excessive quantities are on hand operations management is responsible for finding vendors that supply the appropriate goods at reasonable prices and have the ability to deliver the product when needed another large facet of operations management involves the delivery of goods to customers this includes ensuring that products are delivered within the agreed time commitment operations management also typically follows up with customers to ensure that the products meet quality and functionality needs finally operations management takes the feedback received and distributes the relevant information to each department to use in process improvement | |
what operations managers do | operations managers are involved in coordinating and developing new processes while reevaluating current structures organization and productivity are two key drivers of being an operations manager and the work often requires versatility and innovation as part of their daily responsibilities operations managers must possess a variety of skill sets including 2a master of business administration mba degree in operations management can provide global perspective on industry trends and an awareness of financial regulations and political uncertainties that can affect an organization it also provides a solid grasp of the inherent complexities and the tools needed to respond well to change | |
what is the purpose of operations management | operations management om is concerned with controlling the production process and business operations in the most efficient manner possible om professionals attempt to balance operating costs with revenue to maximize net operating profit | |
what are some systems of operations management | modern operations management revolves around four theories | |
what is an example of operations management | operations management is prevalent and most easily understood in the healthcare sector the current healthcare system overuses expensive technological and emergency based treatment high costs from care often remain uncompensated due to uninsured patients the prevalence of services in expensive settings creates a burden on taxpayers health insurance holders and healthcare institutions the bottom linein simple terms operations management om is the process of prioritizing and employing business practices designed to achieve maximum efficiency as a means to achieve maximum profitability within the process operations managers utilize organization and productivity to achieve their primary goals balancing the efficient use of resources including staff materials equipment and technology is key to a successful om process and by extension the success of the company | |
what is opportunity cost | opportunity cost represents the potential benefits that a business an investor or an individual consumer misses out on when choosing one alternative over another while opportunity costs can t be predicted with total certainty taking them into consideration can lead to better decision making investopedia mira norianformula for calculating opportunity costwe can express opportunity cost in terms of a return or profit on investment by using the following mathematical formula opportunity cost rmpic ricp where rmpic return on most profitable investment choice ricp return on investment chosen to pursue begin aligned text opportunity cost text rmpic text ricp textbf where text rmpic text return on most profitable investment choice text ricp text return on investment chosen to pursue end aligned opportunity cost rmpic ricpwhere rmpic return on most profitable investment choicericp return on investment chosen to pursue the formula for this calculatin is simply the difference between the expected returns of each option consider a company that is faced with the following two mutually exclusive options option a invest excess capital in the stock marketoption b invest excess capital back into the business for new equipment to increase productionassume the expected return on investment roi in the stock market is 10 over the next year while the company estimates that the equipment update would generate an 8 return over the same time period the opportunity cost of choosing the equipment over the stock market is 2 10 8 in other words by investing in the business the company would forgo the opportunity to earn a higher return at least for that first year | |
when considering two different securities it is also important to take risk into account for example comparing a treasury bill to a highly volatile stock can be misleading even if both have the same expected return so that the opportunity cost of either option is 0 that s because the u s government backs the return on the t bill making it virtually risk free and there is no such guarantee in the stock market | opportunity cost and capital structureopportunity cost analysis can play a crucial role in determining a company s capital structure a business incurs an explicit cost in taking on debt or issuing equity because it must compensate its lenders or shareholders and each option also carries an opportunity cost money that a company uses to make payments on its bonds or other debt for example cannot be invested for other purposes so the company must decide if an expansion or other growth opportunity made possible by borrowing would generate greater profits than it could make through outside investments companies try to weigh the costs and benefits of borrowing money vs issuing stock including both monetary and non monetary considerations to arrive at an optimal balance that minimizes opportunity costs because opportunity cost is a forward looking consideration the actual rate of return ror for both options is unknown at that point making this evaluation tricky in practice example of an opportunity cost analysis for a businessassume that a business has 20 000 in available funds and must choose between investing the money in securities which it expects to return 10 a year or using it to purchase new machinery no matter which option the business chooses the potential profit that it gives up by not investing in the other option is the opportunity cost if a business decision is made to go with the securities option its investment would theoretically gain 2 000 in the first year 2 200 in the second and 2 420 in the third alternatively if the business purchases a new machine it will be able to increase its production knowing that the machine setup and employee training will be intensive and the new machine will not be up to maximum efficiency for the first couple of years the company estimates that it would net an additional 500 in profit in the first year then 2 000 in year two and 5 000 in all future years by these calculations choosing the securities makes sense in the first and second years however by the third year an analysis of the opportunity cost indicates that the new machine is the better option 500 2 000 5 000 2 000 2 200 2 420 880 one of the most dramatic examples of opportunity cost is a 2010 exchange of 10 000 bitcoins for two large pizzas at the time worth about 41 1 as of june 2024 those 10 000 bitcoins would be worth over 610 million 2example of an opportunity cost analysis for an individualindividuals also face decisions involving such missed opportunities even if the stakes are often smaller suppose for example that you ve just received an unexpected 1 000 bonus at work you could simply spend it now such as on a spur of the moment vacation or invest it for a future trip for example if you were to invest the entire amount in a safe one year certificate of deposit at 5 you d have 1 050 to play with next year at this time you d also face an opportunity cost with your vacation days at work if you use some of them now with your spare 1 000 you won t have them next year assuming your employer lets you roll them over from year to year as with many similar decisions there is no right or wrong answer here but it can be a helpful exercise to think it through and decide what you most want explicit vs implicit costscompany expenses are broadly divided into two categories explicit costs and implicit costs the former are expenses like rents salaries and other operating expenses that are paid with a company s tangible assets and recorded within a company financial statements by contrast implicit costs are technically not incurred and cannot be measured accurately for accounting purposes there are no cash exchanges in the realization of implicit costs instead they are opportunity costs making them synonymous with imputed costs while explicit costs are considered out of pocket expenses opportunity cost vs sunk costa sunk cost is money already spent at some point in the past while opportunity cost is the potential returns not earned in the future on an investment because the money was invested elsewhere when considering the latter any sunk costs previously incurred are typically ignored 3buying 1 000 shares of company a at 10 a share for instance represents a sunk cost of 10 000 this is the amount of money paid out to invest and it can t be recouped without selling the stock and perhaps not in full even then from an accounting perspective a sunk cost also could refer to the initial outlay to purchase an expensive piece of heavy equipment which might be amortized over time but which is sunk in the sense that the company won t be getting the money back opportunity cost vs riskin economics risk describes the possibility that an investment s actual and projected returns will be different and that the investor may lose some or all of their capital opportunity cost reflects the possibility that the returns of a chosen investment will be lower than the returns of a forgone investment the key difference is that risk compares the actual performance of an investment against the projected performance of the same investment while opportunity cost compares the projected performance of an investment against the projected performance of another investment accounting profit vs economic profitaccounting profit is the net income calculation often stipulated by the generally accepted accounting principles gaap used by most companies in the u s under those rules only explicit real costs are subtracted from total revenue economic profit however includes opportunity cost as an expense this theoretical calculation can then be used to compare the actual profit of the company to what its profit might have been had it made different decisions economic profit and any other calculation that considers opportunity cost is strictly an internal value used for strategic decision making | |
what is a simple definition of opportunity cost | the term refers to the hidden cost associated with not taking an alternative course of action | |
what is an example of opportunity cost in investing | consider a young investor who decides to put 5 000 into bonds each year and dutifully does so for 50 years assuming an average annual return of 2 5 their portfolio at the end of that time would be worth nearly 500 000 although this result might seem impressive it is less so when you consider the investor s opportunity cost if for example they had instead invested half of their money in the stock market and received an average blended return of 5 a year their portfolio would have been worth more than 1 million their opportunity cost in this case would be over 500 000 | |
how do you predict opportunity cost | any effort to make a prediction must rely heavily on estimates and assumptions there s no way of knowing exactly how a different course of action will play out financially over time investors might use the historic returns on various types of investments in an attempt to forecast the likely returns of their investment decisions however as the famous disclaimer goes past performance is no guarantee of future results 4the bottom linewhile opportunity costs can t be predicted with absolute certainty they provide a way for companies and individuals to think through their investment options and ideally arrive at better decisions | |
what is the oprah effect | the oprah effect refers to the boost in sales that followed an endorsement on the oprah winfrey show which aired on tv for 25 years a recommendation from oprah the queen of talk shows turned many fashion and lifestyle products into multimillion dollar companies understanding the oprah effectmany businesses and people who were lucky enough to appeal to oprah winfrey found overnight success after being promoted on her groundbreaking show which ran from 1986 to 2011 and was the highest rated daytime talk show in american tv history the oprah effect was especially powerful because of her authenticity oprah chose products she was genuinely interested in rather than being paid to promote them and unlike typical celebrity endorsements she supported independent family businesses thanks to oprah tv personalities like psychologist dr phil health expert dr oz and tv cook rachael ray have all become household names with their own tv shows she also had a huge impact on publishing oprah s book club promoted reading and turned books into immediate best sellers today oprah is a billionaire and a media mogul she launched own the oprah winfrey network in 2011 1 and while her 10 investment in ww international inc ww commonly known as weight watchers in 2015 has proved that not everything she touches turns to gold instantly the dieting company faces stiff competition from mobile apps and fitness trackers she still has millions of loyal fans and high approval ratings 2oprah effect exampleswhile his interior design firm had been around since 1995 nate berkus received a major boost to his career after appearing on oprah in 2002 thereafter he appeared regularly on her show and his design firm has thrived on the publicity oprah s production company harpo also co produced berkus s daytime show 3the oprah effect was most pronounced for the publishing industry according to available statistics 59 books chosen by oprah for her book club appeared on usa today s top 10 list and 22 reached the no 1 position nobel laureate toni morrison s books are supposed to have received a bigger boost in sales from oprah s recommendations than from winning the prize itself 4 | |
what is optimal capital structure | the optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company s market value while minimizing its cost of capital in theory debt financing offers the lowest cost of capital due to its tax deductibility however too much debt increases the financial risk to shareholders and the return on equity that they require thus companies have to find the optimal point at which the marginal benefit of debt equals the marginal cost investopedia michela buttignolunderstanding optimal capital structurethe optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the weighted average cost of capital wacc of a company while maximizing its market value the lower the cost of capital the greater the present value of the firm s future cash flows discounted by the wacc thus the chief goal of any corporate finance department should be to find the optimal capital structure that will result in the lowest wacc and the maximum value of the company shareholder wealth according to economists franco modigliani and merton miller in the absence of taxes bankruptcy costs agency costs and asymmetric information in an efficient market the value of a firm is unaffected by its capital structure 1optimal capital structure and waccthe cost of debt is less expensive than equity because it is less risky the required return needed to compensate debt investors is less than the required return needed to compensate equity investors because interest payments have priority over dividends and debt holders receive priority in the event of a liquidation debt is also cheaper than equity because companies get tax relief on interest while dividend payments are paid out of after tax income however there is a limit to the amount of debt a company should have because an excessive amount of debt increases interest payments the volatility of earnings and the risk of bankruptcy this increase in the financial risk to shareholders means that they will require a greater return to compensate them which increases the wacc and lowers the market value of a business the optimal structure involves using enough equity to mitigate the risk of being unable to pay back the debt taking into account the variability of the business s cash flow companies with consistent cash flows can tolerate a much larger debt load and will have a much higher percentage of debt in their optimal capital structure conversely a company with volatile cash flows will have little debt and a large amount of equity determining the optimal capital structureas it can be difficult to pinpoint the optimal capital structure managers usually attempt to operate within a range of values they also have to take into account the signals their financing decisions send to the market a company with good prospects will try to raise capital using debt rather than equity to avoid dilution and sending any negative signals to the market announcements made about a company taking debt are typically seen as positive news which is known as debt signaling if a company raises too much capital during a given time period the costs of debt preferred stock and common equity will begin to rise and as this occurs the marginal cost of capital will also rise to gauge how risky a company is potential equity investors look at the debt equity ratio they also compare the amount of leverage other businesses in the same industry are using on the assumption that these companies are operating with an optimal capital structure to see if the company is employing an unusual amount of debt within its capital structure another way to determine optimal debt to equity levels is to think like a bank what is the optimal level of debt a bank is willing to lend an analyst may also utilize other debt ratios to put the company into a credit profile using a bond rating the default spread attached to the bond rating can then be used for the spread above the risk free rate of a aaa rated company limitations of optimal capital structureunfortunately there is no magic ratio of debt to equity to use as guidance to achieve real world optimal capital structure what defines a healthy blend of debt and equity varies according to the industries involved line of business and a firm s stage of development and can also vary over time due to external changes in interest rates and regulatory environment however because investors are better off putting their money into companies with strong balance sheets it makes sense that the optimal balance generally should reflect lower levels of debt and higher levels of equity theories on capital structurethe modigliani miller m m theorem is a capital structure approach named after franco modigliani and merton miller modigliani and miller were two economics professors who studied capital structure theory and collaborated to develop the capital structure irrelevance proposition in 1958 1this proposition states that in perfect markets the capital structure a company uses doesn t matter because the market value of a firm is determined by its earning power and the risk of its underlying assets according to modigliani and miller value is independent of the method of financing used and a company s investments 1 the m m theorem made the two following propositions this proposition says that the capital structure is irrelevant to the value of a firm the value of two identical firms would remain the same and value would not be affected by the choice of financing adopted to finance the assets the value of a firm is dependent on the expected future earnings it is when there are no taxes 2this proposition says that the financial leverage boosts the value of a firm and reduces wacc it is when tax information is available while the modigliani miller theorem is studied in finance real firms do face taxes credit risk transaction costs and inefficient markets which makes the mix of debt and equity financing important 3the pecking order theory focuses on asymmetrical information costs this approach assumes that companies prioritize their financing strategy based on the path of least resistance internal financing is the first preferred method followed by debt and external equity financing as a last resort | |
what is an optimal currency area oca | an optimal currency area oca is the geographic area in which a single currency would create the greatest economic benefit while traditionally each country has maintained its own separate national currency work by robert mundell in the 1960s theorized that this might not be the most efficient economic arrangement 1in particular countries that share strong economic ties may benefit from a common currency this allows for closer integration of capital markets and facilitates trade however a common currency results in a loss of each country s ability to direct fiscal and monetary policy interventions to stabilize their individual economies understanding optimal currency areas ocas in 1961 canadian economist robert mundell published his theory of the oca with stationary expectations he outlined the criteria necessary for a region to qualify as an oca and benefit from a common currency in this model the primary concern is that asymmetric shocks may undermine the benefit of the oca if large asymmetric shocks are common and the criteria for an oca are not met then a system of separate currencies with floating exchange rates would be more suitable in order to deal with the negative effects of such shocks within the single country experiencing them 1according to mundell there are four main criteria for an oca 1other criteria have been suggested by later economic research 45europe debt crises and the ocathe oca theory had its primary test with the introduction of the euro as a common currency across european nations eurozone countries matched some of mundell s criteria for successful monetary union providing the impetus for the introduction of a common currency while the eurozone has seen many benefits from the introduction of the euro it has also experienced problems such as the greek debt crisis thus the long term outcome of a monetary union under the theory of ocas remains a subject of debate the european sovereign debt crisis in the wake of the great recession is cited as evidence that the emu did not fit the criteria for a successful oca critics argue that the emu did not adequately provide for the greater economic and fiscal integration necessary for cross border risk sharing technically the european stability and growth pact included a no bailout clause that specifically restricted fiscal transfers however in practice this was abandoned early on in the sovereign debt crisis 6 as greece s sovereign debt crisis continued to worsen there was discussion suggesting that the emu must account for risk sharing policies far more extensive than the adopted provisional bailout system 78overall this episode implies that due to the asymmetry of the economic shock to greece relative to other countries in the emu and apparent shortfalls in the emu s qualification as an oca under mundell s criteria greece and perhaps other countries might not actually fall within the oca for the euro | |
what is an optimization | optimization is the process of making a trading system more effective by adjusting the variables used for technical analysis a trading system can be optimized by reducing certain transaction costs or risks or by targeting assets with greater expected returns | |
how an optimization works | broadly speaking optimization is the act of changing an existing process in order to increase the occurrence of favorable outcomes and decrease the occurrence of undesirable outcomes this can be used to make a business model more profitable increase the expected returns on an investment portfolio or decrease the expected costs of a trading system each optimization depends upon a certain number of assumptions about real world variables for example an investor seeking to optimize their portfolio would begin by assessing factors such as market risk and the likelihood that certain investments may outperform others since there is no way to calculate these variables in real time the investor s optimization strategy would depend upon how well they estimate these factors there may be multiple paths to optimization depending on the assumptions underlying an optimization strategy some traders might optimize their strategy with a number of short term trades to take advantage of predictable price swings others might optimize by reducing the number of trades in order to reduce their transaction costs in either case the success of an optimization strategy will depend on how well the investor has identified the risks costs and potential payouts of their strategy because market conditions are constantly changing optimizing one s trading system is an going process like trying to hit a moving target who uses trading systems for technical analysis trading systems can be used by just about anyone individual investors and major institutions alike may have systems that they rely on to provide detailed information to help them choose investment strategies individuals acting on their own behalf may have rudimentary systems that they have created themselves that may not require technological experience or coding knowledge there are also trading systems available online that anyone can take advantage of a google search for trading systems will result in lists of both free systems and ones that require payment or membership to use institutions will rely on more sophisticated systems many will have their own systems designed to be used in house these systems will be more advanced and offer more options for optimizing than the free ones novice or casual traders can find online whatever system an investor uses they should use it with the knowledge that data can still report incorrectly and systems can fail a trading system is just another tool investors can use when investing it does not replace the need for critical thinking advantages and disadvantages of optimizationbusiness optimization is an important element of the market economy as companies compete against one another to increase profits and reduce costs they also find ways to provide improved products and lower prices to their consumers they may also find ways to use resources more efficiently reduce pollution and other externalities in the world of investments there are few drawbacks to a well executed optimization by identifying missed opportunities and eliminating underperforming assets an optimized portfolio can produce potentially higher investment returns however most optimizations come with tradeoffs and opportunity costs in other areas for example a fund that optimizes to reduce its risk profile is also likely to miss out on the payoffs of certain high risk strategies and a company that optimizes by reducing labor costs might find itself short staffed in the event of a sudden increase in demand when companies try to fine tune to increasing levels of precision there is a danger that they may over optimize by reducing their preparedness for an unexpected eventuality optimization helps businesses reduce costs and increase revenues optimization also benefits the market by reducing deadweight and inefficiencies optimizing one parameter typically comes with tradeoffs in others there is a risk of over optimization as companies reduce their preparedness for unexpected contingencies changing market conditions might reduce the effectiveness of optimization example of optimizationan interesting example of business optimization occurs in supply chain management the industry concerned with the large scale transportation and storage of trade goods around the world in order to keep operations running smoothly most industrial enterprises rely upon a large network of logistics providers and suppliers to keep their factories running beginning in the 1970s companies like toyota began optimizing their inventory systems with just in time production by manufacturing and delivering items as they were needed this system allowed manufacturers to reduce the costs associated with storage and warehousing however jit manufacturing requires a fine tuned logistics system and the ability to accurately forecast future demand it also comes with tradeoffs in terms of flexibility and resilience since there is little room for error any delay in deliveries could have a compounding effect on the supply chain potentially causing production to stall the bottom lineoptimization is an important process in maintaining a business or trading system by adjusting system parameters to reduce costs and maximize output optimization allows businesses and traders to become more efficient and competitive | |
what is mathematical optimization | mathematical optimization is a field of applied mathematics that seeks to find a combination of input variables that maximizes or minimizes the output return of a multi variable function when used in business these techniques could be used to fine tune production processes to minimize certain costs or increase per unit output | |
what does optimization mean in business | in business optimization is the process of fine tuning a business strategy or process in order to improve efficiency or reduce costs this can be done by using resources more efficiently cutting costs or investing in labor saving technologies | |
what is search engine optimization | search engine optimization or seo is the process of fine tuning an online article or website in order to reach more potential readers through online search this is typically done by strategically placing keywords or related phrases in order to rank higher in search engine results | |
what is conversion rate optimization | in sales conversion is the process of turning potential leads into customers conversion rate optimization is a process of increasing the number of new customers in order to increase sales this can be done by improved marketing sales training or otherwise making their product more appealing | |
what is an optimized portfolio as listed securities opals | optimized portfolio as listed securities is a single country equity index that contains fewer holdings than the benchmarked index optimized portfolio as listed securities was created by morgan stanley in 1994 it is seen as a predecessor to the popularity of exchange traded funds understanding an optimized portfolio as listed securities opals optimized portfolios as listed securities are designed to track a single country index but they are expected to outperform the index by containing fewer holdings in other words by being optimized the portfolios may be sold before expiration or settled by physical delivery of the underlying shares the product is designed for cross border equity investors who cannot use futures efficiently or cannot use futures for regulatory reasons and who cannot justify running their own country by country equity operation optimized portfolio as listed securities and portfolio optimizationportfolio optimization is the process of selecting the best portfolio asset allocation out of a set of all possible portfolios being considered to achieve an objective this process typically attempts to maximize factors such as expected return while minimizing factors such as expenses volatility and risk the optimal portfolio varies and is influenced by each individual investor s return objectives and risk tolerance portfolio optimization often takes place in two stages optimizing weights of asset classes and optimizing weights of securities within the same asset class optimizing asset class weighting would include decisions like choosing the percentage of a portfolio placed in equities versus bonds or real estate while an example of the security selection would involve selecting exactly which equities or bonds are held holding some of the portfolio in each class provides some diversification and holding various specific assets within each class affords further diversification optimized portfolio as listed securities listingsoptimized portfolios as listed securities trade on the luxembourg stock exchange they are available for many of the different morgan stanley capital international msci indices the portfolios are typically purchased only by large institutional investors they have a 100 million minimum investment and they are not registered with the u s securities and exchange commission so they are generally unavailable to the majority of u s investors optimized portfolios as listed securities are often seen as one of several predecessors to the introduction of exchange traded funds in the united states optimized portfolios were introduced on the luxembourg stock exchange because the exchange s more permissive rules allowed morgan stanley to offer the shares to retail investors in 1996 morgan stanley introduced world equity benchmark shares webs these were sec registered units similar to optimized portfolios as listed securities and available to u s retail investors | |
what is optimum currency area oca theory | optimum currency area theory oca states that specific areas not bounded by national borders would benefit from a common currency in other words geographic regions may be better off using the same currency instead of each country within that geographic region using its own currency understanding optimum currency area oca theorysharing a currency can benefit a geographic region by significantly increasing trade however this trade must outweigh the costs of each country giving up a national currency as an instrument to adjust monetary policy areas using oca theory can still maintain a flexible exchange rate system with the rest of the world oca theory was developed in 1961 by canadian economist robert mundell based on earlier work by abba lerner it speculates that there is an optimum geopolitical area that should share a currency but this geopolitical area doesn t necessarily correspond with national borders an optimum currency area could be several nations parts of several nations or regions inside a single nation 1according to the theory a common currency can maximize economic efficiency provided that the participants meet the following four criteria 3princeton professor and international economist peter kenen suggested the addition of a fifth criterion of production diversification within the geopolitical area 4the u s as an optimum currency areasome economists argue that the united states should be divided into several smaller currency areas as the country as a whole does not fit the criteria listed in mundell s original oca theory economists have calculated that the southeast and southwest regions of the united states do not necessarily fit with the rest of the country as an oca 5example of the oca theorymany point to the euro as proof of oca theory in action however some argue that the area did not meet the four criteria as laid out by mundell s theory at the time of the euro s creation in 1999 this lack of meeting the requirements they say is the reason the eurozone has struggled since its inception indeed the oca theory was put to the test in 2010 as sovereign debt issues faced by many heavily indebted nations in europe threatened the viability of the european union eu placing severe strains upon the euro 4according to global financial integrity a non profit located in washington d c peripheral eu countries such as portugal italy ireland greece and spain piigs experienced slowing growth lacked international competitiveness and possessed a labor force that was unproductive 6as these economies slowed private capital fled some to stronger eurozone economies and some to other countries also due to language culture and distance difficulties the labor force in the eurozone is not fluid or mobile wages are not uniform across the geopolitical area either 6 | |
is europe an optimal currency area | technically europe is not an optimal currency area because the countries are not well integrated enough to be so despite this many countries in europe operate under one currency the euro which turned out to be a burden for some countries during the eurozone crisis during the great recession | |
is the u s an optimal currency area | not as a whole but regionally yes the u s is an optimal currency area though the u s is one country and utilizes one currency some regions are specifically integrated enough that the u s could use different currencies in these regions for optimization these regions have similar business cycles and would respond similarly to economic issues | |
what are the benefits of an optimum currency area | some of the benefits of an optimum currency area include the removal of uncertainty through shifting exchange rates increased flow of trade amongst member countries specialization in production stability in prices and a reduction in costs the bottom linethe optimum currency area oca theory believes that countries within a certain geographic region would be better served using the same currency rather than their own individual currencies this has been implemented for example in europe with the euro however many economists state how the euro did not meet the criteria of the theory and therefore is partly why it has struggled from time to time | |
what is an option adjustable rate mortgage option arm | an option adjustable rate mortgage option arm is a type of arm mortgage where the borrower has several options as to which type of payment is made to the lender in addition to having the choice of making payments of interest and principal that amounts to those made in conventional mortgages option arms also have alternative payment options where the mortgagor can make significantly smaller payments by making interest only payments or minimum payments an option arm is also known as a flexible payment arm understanding option armssince many option arms offer a low teaser rate many mortgagors unknowingly refinance their present mortgage in hopes of making lower payments unfortunately once these short term teaser rates expire the rates of interest are returned back to those similar to conventional mortgages furthermore for those unlucky mortgagors that elected to take the minimum payments arm option they will find that the principal owed on their mortgage has actually increased this is because the value of minimum payments did not entirely cover the mortgage s interest the uncovered interest would then be added to the mortgage s principal option arms were popular before the subprime mortgage crisis of 2007 2008 when home prices rose rapidly the mortgages had a very low introductory teaser interest rate typically one percent which led many people to assume they could afford more home than their income might suggest but the teaser rate was only for one month then the interest rate reset to an index such as the wells cost of saving index cosi plus a margin often resulting in payment shock since 2014 regulations option arms have been less popular ways option arms are paidin a common scenario the lender may let the borrower with an option arm decide each month what type of payment they want to make these choices can include making a minimum payment making an interest only payment making a fully amortized payment on a 15 year mortgage or making an amortized payment on a 30 year mortgage the consumer financial protection bureau cfpb effectively eliminated option arms in 2014 via new qualified mortgage qm standards 1while the choices available with an option arm allow for more flexibility on payments the borrower could easily be saddled with more long term debt than they started with as with other adjustable rate mortgages there is the possibility of interest rates changing drastically and rapidly based on the market an option arm may appeal to households where income can fluctuate such as with professions who operate on commission contract or as freelancers if they do not see as much work come their way choosing to pay the minimum on a mortgage although this may allow them to keep more money in hand the minimum amount can increase annually furthermore the minimum payment might be recast at five or 10 year intervals to a fully amortizing payment these caveats may go overlooked by borrowers which may leave them unprepared for the potential rising costs and increasing principal balance if the borrower continues to make just the minimum payment and the unpaid balance grows to exceed the original value of the mortgage say 110 or more then the mortgage could automatically reset option arms have been cited as contributors to the housing crisis that developed after borrowers sought such financing for homes they could not afford to pay off 2 in those instances borrowers paid just the minimum amount due each month with an option arm then eventually found themselves unable to pay for their homes or the mortgage grew large while the sale value of the home fell | |
what is option adjusted spread oas | the option adjusted spread oas is the measurement of the spread of a fixed income security rate and the risk free rate of return which is then adjusted to take into account an embedded option typically an analyst uses treasury yields for the risk free rate the spread is added to the fixed income security price to make the risk free bond price the same as the bond investopedia zoe hansenunderstanding option adjusted spread oas the option adjusted spread helps investors compare a fixed income security s cash flows to reference rates while also valuing embedded options against general market volatility by separately analyzing the security into a bond and the embedded option analysts can determine whether the investment is worthwhile at a given price the oas method is more accurate than simply comparing a bond s yield to maturity to a benchmark the option adjusted spread considers historical data as the variability of interest rates and prepayment rates these factors calculations are complex since they attempt to model future changes in interest rates prepayment behavior of mortgage borrowers and the probability of early redemption more advanced statistical modeling methods such as monte carlo analysis are often used to predict prepayment probabilities options and volatilitya bond s yield to maturity ytm is the yield on a benchmark security which can be a treasury security with a similar maturity plus a premium or spread above the risk free rate to compensate investors for the added risk the analysis gets more complicated when a bond has embedded options these are call options which give the issuer the right to redeem the bond prior to maturity at a preset price and put options that allow the holder to sell the bond back to the company on certain dates the oas adjusts the spread in order to account for the potential changing cash flows the oas takes into account two types of volatility facing fixed income investments with embedded options changing interest rates which affect all bonds and prepayment risk the shortfall of this approach is that estimates are based on historical data but are used in a forward looking model for example prepayment is typically estimated from historical data and does not take into account economic shifts or other changes that might occur in the future oas vs z spreadthe oas should not be confused with a z spread the z spread is the constant spread that makes the bond s price equal to the present value of its cash flow along each point along the treasury curve however it does not include the value of the embedded options which can have a big impact on the present value the z spread is also known as the static spread because of the consistent feature the oas effectively adjusts the z spread to include the value of the embedded option it is therefore a dynamic pricing model that is highly dependent on the model being used also it allows for the comparison using the market interest rate and the possibility of the bond being called early known as prepayment risk example mortgage backed securitiesas an example mortgage backed securities mbs often have embedded options due to the prepayment risk associated with the underlying mortgages as such the embedded option can have a significant impact on the future cash flows and the present value of the mbs oas is therefore particularly useful in the valuation of mortgage backed securities in this sense the prepayment risk is the risk that the property owner may pay back the value of the mortgage before it is due this risk increases as interest rates fall a larger oas implies a greater return for greater risks | |
what is an options contract | an options contract is a financial agreement that grants the buyer the right but not the obligation to buy or sell a particular asset like a stock at a preset price within a given period as financial markets have grown increasingly complex and at times more volatile options have emerged as a potent way to guard against uncertainty and capitalize on price changes in just a couple of decades options with their ability to leverage gains manage risk and strategic flexibility have moved from an esoteric tool for professionals into a mainstream vehicle from individual investors to large institutional players many market participants use options for speculation hedging and generating income the numbers tell the story trading volume in options has increased by about 150 in the past decade and about 15 fold since 2000 the vast increase in options trading has been helped by a massive spike in retail investor interest which peaked at almost 50 of all trading volume during the pandemic and has remained in the low 40s by percentage for most months since 1below we take you through what you need to know about these contracts how they work who trades them and why and the advantages and pitfalls to avoid should you add them to your trading strategy understanding options contractsoptions contracts are valued based on the underlying securities these contracts allow the buyer to buy or sell depending on the type of contract they hold the underlying asset at a price set out in the agreement either within a specific time frame or at the expiration date the underlying assets include currencies stocks indexes interest rates exchange traded funds and more 2the terms of option contracts specify the underlying security the price at which that security can be bought or sold the strike price and the expiration date of the contract for stocks a standard contract covers 100 shares but this number can be adjusted for stock splits special dividends or mergers options are generally used for hedging purposes but can also be employed to speculate on price moves the contracts generally cost a fraction of what the underlying shares would options can provide leverage meaning that the premium allows you to be exposed to a larger position of shares for a fraction of the cost of buying the underlying security in exchange for this right the buyer of the option pays a premium to the party selling the option options strategies are adaptable to various market conditions traders buy or sell options contracts based on whether they are bullish or bearish on the underlying asset and they often use strategies that combine several options and long positions owning the asset outright at once 3types of options contractsthere are two types of options contracts puts and calls both can be bought to speculate to profit on price changes or hedge exposure that is to insure positions you already have or may have they can also be sold to generate income 4in general call options can be bought as a leveraged bet on the appreciation of a stock or index while put options are purchased to profit from price declines the buyer of a call option has the right but not the obligation to buy the number of shares covered in the contract at the strike price put buyers meanwhile have the right but not the obligation to sell the shares at the strike price specified in the contract 2option sellers known as writers are obligated to perform their side of the trade if the buyer decides to execute or assigns the call option and buy the underlying security or execute a put option to sell here s how it occurs | |
when trading volume or volatility is relatively low and the market is trending upward traders often buy one or more calls since call options tend to appreciate in value as the underlying asset s price rises meanwhile traders tend to buy puts when volume or volatility is relatively low and the market is trending downward since puts increase in value when the market declines during market downturns option traders often sell calls while they sell puts when the market is advancing 5 | american options can be exercised any time before the expiration date of the option while european options can only be exercised on the expiration date or the exercise date hedging and speculating with options contractsoptions can be an effective tool for hedging as they allow investors to protect their investments against downside risk while retaining the possibility of upside gain typically hedging involves taking an offsetting position in a related security such as a call or put option suppose you re a portfolio manager focusing on equities you want to protect the portfolio from a potential downturn and might buy put options for the stocks on the portfolio if stock prices fall the put options will increase in value offsetting the losses in the portfolio options are also widely used for speculative purposes because of their inherent leverage since options allow you to control a large amount of a stock or other underlying asset through a relatively small premium they can offer increased speculative prospects suppose you expect a company s stock price will rise and buy call options if the stock price increases beyond the strike price of the options you earn a profit that is a multiple of the initial premium paid on the other hand if an investor believes a stock s price is about to fall they might buy put options a drop in the stock price below the strike price can lead to significant gains relative to the initial premium let s put this idea of leverage into action suppose abc stock trades at 100 per share you think that the price is about to jump in the next month you can do two things now let s fast forward one month and assume the stock price has risen to 120 per share congratulations your analysis was correct if you took the first choice above you would profit 2 000 less fees and taxes 120 100 100 shares in the second scenario the option you bought at the money is now in the money the likely price for the one call you bought would now have risen to 20 per contract 20 x 100 2 000 less the premium paid of 200 for a total gain of 1 800 but say instead you had decided to spend the 10 000 on the same option position and all the variables remained the same the initial 10 000 would have got you 10 000 200 50 option contracts when the price of the underlying rises to 120 per share the options would have likely risen to 20 x 100 2000 per contract you bought 50 contracts and therefore the total price of the position would be 2 000 x 50 100 000 less the cost of the options 200 x 50 10 000 total profit without factoring in fees and taxes 100 000 10 000 90 000 this shows you the potential for profit using the leverage that options trading allows however options are a wasting financial instrument and are therefore subject to increased risk of loss one strategy options traders use is called a protective put this is a popular strategy because it generates income and reduces some risk of being long on the stock alone to execute the plan you buy the underlying asset as you usually would and simultaneously write or sell a call option on those same shares options contracts risks and rewardsoptions trading involves strategies ranging from basic hedging or protective measures to complex speculative ventures while the potential for profit with options can be substantial the risks are significant calls and puts are potent tools to improve or protect a portfolio s performance against losses however they require an excellent understanding of market dynamics and the factors influencing option pricing such as time decay and volatility before participating in options trading you should understand whether the market conditions and underlying securities are favorable in addition consider the time frame involved you should try to match the option s expiration with the expected timing of the asset s price moves finally you need a clear plan for when to sell or exercise the option based on the asset s performance if an option reaches expiration with a strike price higher than the asset s market price it expires worthless or out of the money call options risks and rewardstrading call options can involve high risks there is a potential loss of the entire premium paid if the stock doesn t rise above the strike price by expiration the call option will expire worthless resulting in a total loss of the premium there s also the risk of time decay options are time sensitive instruments the value of call options erodes as the expiration date approaches which can result in losses if the stock s price doesn t rise above the strike price by expiration moreover call options are sensitive to volatility the price of call options can fluctuate widely because of price changes for the underlying stock high volatility can increase premium costs that are not linked to favorable moves in the stock price despite these risks call options have several advantages buying call options gives you more control over a relatively larger amount of stock than just purchasing the stock outright for the same amount this leverage means that returns can be amplified in addition the maximum loss for buying call options is limited to the premium paid no matter how much the underlying stock decreases in price lastly calls can be used for various strategic purposes including speculative gains income via premium collection and as part of more complex options strategies put options risks and rewardsjust like call options put options can expire worthless leading to a total loss of the premium paid this can occur if the stock price remains above the strike price also put options suffer from time decay meaning that they lose value as the expiration date nears particularly if the stock price is not moving as expected in highly volatile markets the cost of puts can go up making them an expensive form of insurance nonetheless there are rewards for employing put options puts provide a way to profit from a decline in the stock price without needing to short the stock which can involve further risks and costs puts can also protect you from declines in other investments in a portfolio by offsetting potential losses in the value of the underlying stocks lastly like calls buying puts has a risk limited to the premium paid offering a predefined risk profile example of an options contractcompany abc s shares trade at 60 and a call writer is looking to sell calls at 65 with a one month expiration if the share price stays below 65 and the options expire the call writer keeps the shares and can collect another premium by writing calls again if however the share price appreciates to a price above 65 the buyer calls the shares from the seller purchasing them at 65 the call buyer can also sell the options if purchasing the shares is not the desired outcome | |
are there other derivatives like options | there are several financial derivatives like options including futures contracts forwards and swaps each of these derivatives has specific characteristics uses and risk profiles like options they are for hedging risks speculating on future movements of their underlying assets and improving portfolio diversification 3 | |
what are some options trading strategies | options trading strategies range from basic to highly complex involving single or multiple and simultaneous options positions including covered calls protective puts bull and bear spreads straddles strangles butterfly spreads and calendar spreads each options strategy comes with its own set of risks and rewards before employing them you should consider your market outlook risk tolerance and investment goals for more on these strategies see investopedia s 10 options strategies every investor should know | |
what is natural hedging | natural hedging is a risk management strategy to mitigate the potential negative effects of price or interest rate changes and other financial risks it involves structuring the portfolio so that gains in one asset can offset losses in another without using derivatives the bottom lineoptions contracts are derivatives that grant the holder the right but not the obligation to buy or sell an underlying asset at a preset price before a specific expiration date these contracts come primarily in two forms call options which provide the right to buy and put options which offer the right to sell the underlying asset by paying a premium you can leverage options to hedge against potential losses speculate on price moves or generate income their flexibility and risk management capabilities make them a valuable tool in financial markets but they also require a thorough understanding of their complex mechanics and inherent risks to be used effectively | |
what is an options chain | an options chain also known as an options matrix is a listing of all available options contracts for a given security it shows all listed puts calls their expiration strike prices and volume and pricing information for a single underlying asset within a given maturity period the chain will typically be categorized by expiration date and segmented by calls vs puts an options chain provides detailed quote and price information and should not be confused with an options series or cycle which instead simply denotes the available strike prices or expiration dates understanding option chainsoption chains are probably the most natural form of presenting information for retail investors the option quotes are listed in an easy to understand sequence traders can find an option premium by following the corresponding maturity dates and strike prices depending on the presentation of the data bid ask quotes or mid quotes are also displayable within an option chain the majority of online brokers and stock trading platforms display option quotes in the form of an option chain using real time or delayed data the chain display allows quick scanning of activity open interest and price changes traders can hone in on the specific options required to meet a particular options strategy traders may quickly find an asset s trading activity including the frequency volume of trading and interest by strike price and maturity months sorting of data may be by expiration date soonest to furthest and then further refined by strike price from lowest to highest decoding the option chain matrixthe terms in an options matrix are relatively self explanatory a skilled user can quickly decipher the market regarding price movements and where high and low levels of liquidity occur for efficient trade executions and profitability this is critical information there are four columns of information that traders focus on to assess current market conditions the columns are last price net change bid and ask yahoo financein the columns following the four listed above you will find important information to gauge market size for a given option and how traders are committed at each price level trading volume or the number of contracts that change hands in a given day indicates how much liquidity there might be for any given option open interest meanwhile measures the total number of options outstanding on each strike and maturity allowing you to gauge the scale of market commitment the real level of open interest varies intraday market makers report the information shown in the option chain only at the end of each trading day the option chain matrix is most useful for the next trading day | |
what is an option class | an option class refers to all the call options or all the put options listed on an exchange for a particular underlying asset for example all the calls available for trade on apple inc aapl stock would be part of the same options class all the puts listed on apple would be part of another related class the number of options available for purchase or sale within a given option class will depend on the size and trading volume of the underlying asset as well as overall market conditions understanding option classesoption classes are used to categorize options on an exchange for investors all major public market exchanges use option classes to list the option available for trade on a given underlying asset quite often exchanges and financial sites will break the class up into series an option series is all the calls or puts for various strike prices and with the same expiry for a given underlying asset for example all the calls or puts that expire in june would be an option series an option series is a part of the larger option class therefore when viewing options quotes some sites may show the entire option class but quite often it will be sorted by expiry date series other markets such as over the counter otc or institutional markets may not always use option classes because of the complexity and customized structuring of the options being traded just like with stocks exchange traded options must be traded through a broker who connects with market makers to help facilitate trading option exchanges use standard bid ask pricing models while option prices are generated from advanced analytics their daily trading prices are still influenced by supply and demand in the market broker dealers generally require a minimum of 2 000 in capital for approval of an options trading account rules and regulations for options trading are overseen by the options clearing corporation occ 1an option chain contains all the put and call options for a given underlying asset special considerationsgenerally once access to an options trading platform is established investors will be able to view the full listing of option classes for their preferred underlying security options are usually listed and classified by the ticker on the instrument s underlying asset an options brokerage trading platform will segregate calls and puts on underlying securities calls and puts are usually the two broadest option classes available within each of these classes investors will find a list of available strike prices and expirations the amount of information provided on each option class will typically be based on an investor s subscription preferences some options quotes include advanced analytics such as greeks while other platforms subscriptions may only show the basic contract name strike expiry bid ask last price last trade time date percent change volume open interest and often implied volatility is included as well real world example of an option classsome option classes are large while others are relatively small depending on how popular the options market is for a given underlying asset for example all the calls available for trade on the spdr s p 500 trust spy number in the hundreds on the other hand the option class for barnes group inc b was relatively small as of june 2019 with several options available for trade with two available expiry dates at the time the stock was trading at 54 46 2all the calls above represent the call option class for this stock while the puts represent the put option class for this stock at the time of writing option classes can grow or shrink depending on whether more or fewer options become available due to increased or decreased interest | |
what is an option cycle | option cycle refers to the expiration dates that apply to the different classes of options a newly listed option is assigned a cycle randomly to broadly distribute options across varying time frames it is also known as an expiration cycle with a few exceptions that have contracts every month most equity options are set up on one of three cycles knowing which cycle an option is on tells you when the option can expire if not exercised |
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