Cost analysis assesses a company's profitability and working capital management. Analysts calculate and interpret several cost and profitability measures, including gross, operating and net margins. Operating costs account for the majority of costs for most companies, and they are primarily determined by the company's business model and size.

Operating leverage is the extent to which fixed operating costs (e.g., depreciation, rent) are used in a firm's operations.

Operating profit = [Q x (P - VC)] - FC

P - VC is referred to as the per unit contribution margin. P (price) has to be bigger than VC (variable cost), and Q has to be high enough to cover FC (fixed cost).

If a high percentage of operating costs are fixed costs, operating risk is considered to be high.

Operating leverage is primarily driven by the fixed and variable cost composition of the issuer's operating expenses.

The degree of operating leverage measures the sensitivity of operating profit to changes in sales: DPL = %ΔOperating Profit / %ΔSales

Economies and Diseconomies of Scale

Economies of scale are reductions in the firm's per-unit costs that are associated with the use of large plants to produce a large volume of output. They are present over the initial range of outputs when the long-run ATC curve is falling. There are three reasons why economies of scale exist:

• Mass production is more economical.
• Specialization of labor and equipment improves productivity.
• Workers at a larger firm tend to learn more from their experience.
• Bargaining power in input price.

Diseconomies of scale are situations in which the long-run average total costs are greater in larger firms than they are for smaller firms. They are possible: as a firm gets bigger and bigger, bureaucratic inefficiencies may result; principal-agent problems grow; communication breakdowns and bottlenecks can raise input prices. They are present when the long-run ATC curve is rising.