Identification of the company with higher operating leverage.
Basically, an operating leverage is normally defined as the situation where any given firm or company has an opportunity to increase the income of operations through increasing revenue, ( Morris, Schindehutte, & Allen, 2005) . It is efficiency ratio involved in financial businesses with an aim of measuring total costs percentage (fixed costs) to establish the company’s performance in terms of the utilization of the fixed costs in generating profit
Operating leverage = contribution Margin / Net Operating Income
In this case operating Leverage= Operating earnings/Revenue
Caterpillar, Inc
| 2014 | 2013 | Change | |
| Operating Earnings | 5,328 | 5,628 | (5.6%) |
| Revenue | 55,184 | 55,656 | (0.8%) |
| Costs | 49,856 | 50,028 | |
| Operating leverage (W1) | 7% |
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W1.
Operating leverage= Change in Earning/Revenue
Operating Leverage= 5.6/0.6 =7%
Kroger Company
| 2014 | 2013 | ||
| Operating Earnings | 3,137 | 2,725 | 15.1% |
| Revenue | 108,465 | 98,375 | 10.25% |
| Costs | 105,328 | 95,650 | |
| Operating leverage | 1.47% |
W2.
Operating leverage= Change in Earning/Revenue
Operating Leverage= 15.1/10.25 = 1.47%
Caterpillar Inc has 7% Operating leverage whereas Kroger 1.47%. Therefore, shows that Caterpillar, Inc has the highest Operating leverage
Reasons behind higher operating leverage.
From the findings Caterpillar company might be expected to have a higher operating leverage. A high degree of operating leverage provides an indication that the company has a high proportion of fixed operating costs compared to its variable costs, ( Serfling, 2016) . This means that it uses more fixed assets to support its core business. It also means that the company can make more income from additional sale while keeping its fixed costs intact
Scenario where revenues were Increased by 5% in both companies
Caterpillar, Inc
| 2014 | 2013 | Change | |
| Operating Earnings | 8,087.20 | 8,410.80 | 3.84% |
| Revenue Increased by 5% | 57,943.20 | 58,438.8 | 0.85% |
| Costs | 49,856 | 50,028 | |
| Operating Leverage | 4.52% | ||
Kroger co
| 2014 | 2013 | change | |
| Operating Earnings | 8,560.25 | 7,643.75 | 11.99% |
| Revenue increased by 5% | 113,888.25 | 103,293.75 | 10.26% |
| Costs | 105,328 | 95,650 | |
| Operating leverage | 1.16% |
When revenue is increased by 5% operations earnings will be significantly affected as shown in the tables above for both companies, this is with the considerations that both companies’ costs were held at a constant. The operating earnings and operating leverage will drop proportionally.
References
Morris, M., Schindehutte, M., & Allen, J. (2005). The entrepreneur's business model: toward a unified perspective. Journal of business research , 58 (6), 726-735.
Serfling, M. (2016). Firing costs and capital structure decisions. The Journal of Finance , 71 (5), 2239-2286.
