Question

2. Provide an example of a business or industry that has high operating leverage and one that has low operating leverage and explain why the operating leverage is high or low in each case.

Answer 1

Operating leverage measures a company’s fixed costs as a percentage of its total costs. It is used to evaluate the break even point of a business, as well as the likely profit levels on individual sales. The following two scenarios describe an organization having high operating leverage and low operating leverage.

High operating leverage. A large proportion of the company’s costs are fixed costs. In this case, the firm earns a large profit on each incremental sale, but must attain sufficient sales volume to cover its substantial fixed costs. If it can do so, then the entity will earn a major profit on all sales after it has paid for its fixed costs. However, earnings will be more sensitive to changes in sales volume.

example of a business that has high 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.

Low operating leverage. A large proportion of the company’s sales are variable costs, so it only incurs these costs when there is a sale. In this case, the firm earns a smaller profit on each incremental sale, but does not have to generate much sales volume in order to cover its lower fixed costs. It is easier for this type of company to earn a profit at low sales levels, but it does not earn out sized profits if it can generate additional sales.

example of a business that has low operating leverage

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.