Determining the operating leverage for a company is essential to find out how it will fare on in tough economic times. The ratio is arrived at by diving the contribution margin by the net operating income ( Stelk, Park, & Dugan, 2015 ). The contribution margin refers to the sales less the variable expenses. The companies highlighted, Kroger Co. and Caterpillar Inc., have not stated their variable costs, but it will be easy to find them out based on the nature of their businesses( Sarkar, 2018 ). A firm whose pattern of operating is predictable and involves a specific number of stakeholders will have higher operating leverage than another which handles unique customer requests every time.
Of the two companies, Kroger Co. Seems to have higher leverage than Caterpillar Inc. The situation arises due to the differences in the variable costs of the two businesses, which determines the operating leverage. The higher the variable cost, the lower the leverage. In this case, Kroger Co. is likely to have lower variables costs since its operations are carried out by a certain number of individuals who have distinct roles and they operate in exact stores across the country ( Sarkar, 2018 ). Therefore, the business is likely to have more fixed costs than variable ones. On the other hand, Caterpillar Inc. is involved in an industry where the sale of its goods and services will require a unique workforce and varied techniques. In this manner, its variable costs would be higher.
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The higher operating leverage for Kroger stems from the fact that it has to ensure that its sales more for it to have sufficient revenues to cover its fixed costs. There is a high likely hoped that if it does not position itself well by offering the right products to the right market, it will undergo huge losses ( Bouvard & de Motta, 2018 ). The situation arises since there are various entities which will be waiting to be paid form the company’s earnings. These parties include the employees, the owner of properties they leased and the payments to supermarkets they connect with. Therefore, the business is likely to be affected adversely by changes in the market which do not favor the flow and sale of its items.
Kroger Co. understands its high operating leverage and thus has engaged in various activities to ensure it does not get affected negatively. First, it has diversified its product lines and the number of partners ( Chen, Harford, & Kamara, 2019 ). This move ensures that the company makes the maximum number of sales in a given period. Secondly, the company ah engaged in the process of acquiring and managing stores on its own. This move will help to reduce some of the fixed costs. In the process, operating leverage will reduce. On the other hand, Caterpillar, Inc. may not be worried about the sales it makes at the end of a financial year since it pays its contractors when a sale occurs ( Stelk, Park, & Dugan, 2015 ). Therefore, when there is not the sale of service of reso1urce, the company
If the revenues of both companies increase by 5%, Kroger Co will experience a higher increase in operation earnings. The situation arises since the company has a fixed budget for paying for its operations ( Bouvard & de Motta, 2018 ). Therefore, when it makes more sales, it will not increase fixed costs such as salaries and the cost of leasing properties. Instead, all the additional sales will go to the company directly. However, when the revenues increase for Caterpillar Inc., the operating earnings will remain the same, since, for every sale, the company will have to factor in the cost of paying contractors ( Chen, Harford, & Kamara, 2019 ). In this case, the greater the sales, the higher the costs of enabling such transactions.
References
Bouvard, M., & de Motta, A. (2018, June). Operating Leverage, Risk Taking and Coordination Failures. In Paris December 2018 Finance Meeting EUROFIDAI-AFFI .
Chen, Z., Harford, J., & Kamara, A. (2019). Operating Leverage, Profitability, and Capital Structure. Journal of Financial and Quantitative Analysis , 54 (1), 369-392.
Sarkar, S. (2018). The relationship between operating leverage and financial leverage. Accounting & Finance .
Stelk, S., Park, S. H., & Dugan, M. T. (2015). An additional analysis on operating leverage estimation methods. Journal of Financial Economic Policy , 7 (2), 180-188.
