Operating leverage describes the relationship between fixed assets and variable costs and impacts the extent to which a change in sales will impact the operating income. A company is said to have a high operating leverage if its fixed costs are high in relation to their variable costs. A high operating leverage can be both a positive and a negative thing. When business is doing well and sales are increasing, companies with a high operating leverage will see their Earnings Before Income Tax (EBIT) increase at a higher exponential rate.
However, if sales decrease EBIT will decrease at a quicker rate than the drop in sales and thus maintaining a high operating leverage can be a risky strategy as a downturn in sales may entail that the company is unable to cover their high fixed costs and may subsequently become unprofitable. Operating leverage is therefore a key consideration for anyone evaluating the financial performance of a company as it can assist to explain financial performance, “operating leverage magnifies results, making gains look better and losses look worse”, (Schmedt, 1998). A high operating leverage can, in some circumstances, create additional value.
One example of a company that benefited from a high operating leverage is Microsoft. Software companies typically have high operating leverage as a result of the high fixed costs associated with research and development. During the boom period of the 90s, Microsoft’s profits grew at an average annual rate of 47%. This was almost 10% higher than their sales growth of 38% (Marshall et al, 2003, p435). This discrepancy can be explained by their operating leverage. Every sale they made once they had passed their fixed costs contributed directly to their bottom line, leading to inflated profits.
Since high profits attract investors and additional capital, high operating leverage was a very positive thing for Microsoft during this period. Oasis Airlines Hong Kong is an example of a company that was operating with a high operating leverage. Their fixed costs were generated as the result of the need for them to finance a great deal of their assets with debt. Such debts needed to be repaid, leading to large amounts of fixed costs. Although this situation is unavoidable for airlines due to the costs associated with leasing and buying planes, it is not a positive position to be in.
Demand for airlines services is typically elastic; it will fluctuate according to economic conditions. Such changes in demand will cause earnings fluctuations. For Oasis, their high operating leverage entailed that they did not do particularly well during recent downturn resulting in bankruptcy due to their failure to cover their fixed costs. Other airlines that have been unable to survive economic downturn due to their high operating level include Sabina and Skybus Airlines. The airline industry is thus extremely risky as a result of the high operating leverage nature of their business models.