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

• DOI: http://doi.org/10.1002/jcaf.22472
• Author: Thomas Root,Inchul Suh,John Rozycki
• Date: 01 October 2020
• Published date: 01 October 2020

BLIND PEER REVIEW

From static to dynamic cost structures: The case of the

railroad industry

John Rozycki | Inchul Suh | Thomas Root

College of Business and Public

Administration, Drake University, Des

Moines, Iowa

Correspondence

John Rozycki, College of Business and

Public Administration, Drake University,

Des Moines, IA 50311.

Email: john.rozycki@drake.edu

Abstract

Firms with fixed operating costs have high operating leverage. This leverage

increases the sensitivity of earnings before interest and taxes (EBIT) to changes in

revenues. Railroads have high fixed costs and high operating leverage. One would

rationally expect that a substantial and secular decline in this industry's revenues

would lead to severe and negative effects on operating income and free cash flow.

The industry did indeed experience a secular decline in its most important busi-

ness segment, hauling bituminous coal. In this clinical investigation, we use this

unique industry event to study operating leverage and changes to the industry's

cost structure. Using several methodologies, we measure the changes in the

industry's cost structure and we demonstrate how the changes mitigated the

expected negative effects of its revenue decline. Additionally, we demonstrate that

static measures of an industry's cost structure are likely to produce suboptimal

forecasts. Finally, our findings have implications for financial planning and valua-

tion of firms with high operating leverage, and they provide a renewed impetus

for research into the dynamic relationship between fixed and variable costs.

KEYWORDS

coal, cost structure, degree of operating leverage, elasticity, electric power generation, fixed costs,

railroad industry, variable costs

1|INTRODUCTION

A firm's cost structure consists of fixed costs and variable

costs. Fixed costs are considered to be unchanging within

a relevant range of activity. As units of activity increase,

the fixed costs per unit of activity decline. Variable costs

vary with units of activity but are considered to be fixed

per unit of activity.

The presence of fixed operating costs in a firm's cost

structure increases the sensitivity of earnings before inter-

est and taxes (EBIT) or operating income to changes in

revenues and increases the systematic risk (Brealey,

Myers, & Allen, 2020; Gahlon & Gentry, 1982; Lev, 1974;

Mandelker & Rhee, 1984).Firms with fixed operating costs

have operating leverage. Since EBIT is a substantial part of

free cash flow (FCF), fixed operating costs can be expected

to increase the variability and riskiness of the FCF as well.

Railroads, in particular, have high fixed costs and

high operating leverage. Moreover, aside from their scrap

value, there are few or no alternative uses for specialized

railroad freight cars. The same is true for railroad lines

built to serve specific customers such as coal mines or

coal fired power plants. Hence, one would rationally

expect that substantial decreases in revenues from such

customers would have severe and negative effects on

operating income, free cash flows, and stock valuation.

Indeed, in 2008, the four largest U.S. Class I railroads

(coal haulers) began to experience a severe and unex-

pected secular decline in their most important business

segment, hauling bituminous coal.

Received: 4 May 2020 Revised: 22July 2020 Accepted: 18 August 2020

DOI: 10.1002/jcaf.22472

166 © 2020 Wiley Periodicals LLC J Corp Acct Fin. 2020;31:166–177.wileyonlinelibrary.com/journal/jcaf