Analyzing The Impact of Operating Leverage on Financial Risk and Contribution Margin

Analyzing The Impact of Operating Leverage on Financial Risk and Contribution Margin

When a company has high operating leverage, it means that a significant portion of its costs are fixed and do not change in response to changes in sales volume. Rent, salaries, depreciation, and interest payments are examples of fixed costs. Variable costs, on the other hand, such as raw materials and direct labor, are directly related to production levels and can rise or fall as sales fluctuate (Chen et al., 2019). A company with low operating leverage, on the other hand, has a higher proportion of variable costs. The relationship between fixed and variable costs is the primary reason why a company with high operating leverage faces greater financial risk in a declining sales period than a company with low operating leverage. Even if sales fall, a company with high operating leverage must still cover its fixed costs. Because revenue reductions have a direct impact on profitability, this can result in a more significant drop in EBIT.

In other words, the operating income of the company will be highly sensitive to changes in sales revenue. If sales fall significantly, fixed costs will consume a larger share of the remaining revenue, potentially resulting in losses or lower profits. Conversely, a company with low operating leverage, where most costs are variable, has more flexibility during declining sales periods. As sales decrease, variable costs decrease in proportion, allowing the company to adapt and reduce its expenses more in line with falling revenues (Dorfleitner & Grebler, 2022). Notably, this mitigates the impact on profitability and reduces the financial risk associated with declining sales.

Since the Contribution Margin establishes the company’s capacity to pay its fixed costs, it is closely linked to Operating Leverage. A company that has a higher Contribution Margin is less susceptible to changes in sales revenue because it can more readily pay its fixed costs (Hilton & Platt, 2020). A lower contribution margin, on the other hand, implies that a greater percentage of revenue must be used to pay for variable costs, leaving less for fixed costs and possibly raising the financial risk to the business during periods of declining sales.

References

Chen, Z., Harford, J., & Kamara, A. (2019). Operating leverage, profitability, and capital structure. Journal of financial and quantitative analysis, 54(1), 369-392.

Dorfleitner, G., & Grebler, J. (2022). Corporate social responsibility and systematic risk: International evidence. The Journal of Risk Finance, 23(1), 85-120.

Hilton, R. W., & Platt, D. E. (2020). Managerial accounting: Creating value in a dynamic business environment. McGraw-Hill.

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Companies often use leverage to augment profits. Based on what you learned this week, please explain the following in detail:
With regards to Operating Leverage, please explain why a company with HIGH Operating Leverage faces greater financial risk in a declining sales period compared to a company with LOW Operating Leverage. (HINT: The key here is the relation between fixed costs and variable costs.)
What does a business’s Contribution Margin represent? What does the Contribution Margin have to do with Operating Leverage?