Prior to beginning work on this discussion, please read the Investing Newsletter of Forbes Operating Leverage (Links to an external site.). The Finnish company Rovio Entertainment Corporation (Links to an external site.) that produces and sells the game Angry Birds, following years of falling earnings, job cuts and divestments announced that its revenue increased 34% in 2016 to 190 million euros ($201 million dollars). According to Rosendahl, the operating result improved to a profit of 17.5 million euros from a loss of 21 million in 2015, increasing earnings by 83% (Rosendahl, 2017). In 2015, Rovio Entertainment Corporation announced that its revenues for 2014 decreased nine percent compared to those of 2013; even worse, its earnings had decreased by 73% (Read the article, Investors Take Flight After Angry Birds Maker Warns on Profit (Links to an external site.)).
After reading Forbes’ Investing Newsletter, in an initial post of at least 200 words, explain why relatively small changes in companies’ revenues can result in relatively large changes in their earnings or losses. In other words, if a company’s sales increase 12%, why do its earnings not also increase 12%?
Guided Response: Review several of your peers’ posts. In a post of at least 100 words, respond to at least two of your peers’ posts in a substantive manner. Provide information that they may have missed or may not have considered in regard to operating leverage. A company’s earnings can rise faster, as a percentage, than its revenue due to operating leverage, and operating leverage is due entirely to the fixed costs. Do you agree with your peers’ findings? Why or why not?
You are encouraged to post your required replies earlier in the week to promote more meaningful and interactive discourse in this discussion forum.
Post by classmate 1
A company’s operating leverage can be measured by its contribution margin and operating costs, which depends on high sales and the market’s variable costs influx. A high sales revenue does not necessarily mean an increase in operating income or profit due to the number of units required to be sold and high fixed costs. High operating leverage typically means that the company has high fixed costs. Operating leverage can be used to measure the impact of changes in sales on operating income. For a company’s operating income and operating leverage to provide profitability, variable costs must be considered.
If a company’s sales increase 12%, why do its earnings not also increase 12%?
If the company has a low operating leverage, the increase in sales drastically increases the variable costs; both the variable costs and the fixed costs must be constant for profitability to occur. Now, a company with high fixed costs benefits because the costs are constant and have no impact on production costs. In contrast, variable costs mean additional costs on production if direct labor and direct materials increase due to high production volume; the company may have to look at cheaper venues to acquire direct labor and materials to lower its variable costs. As per the Rovio Entertainment Corporation article, the company reduced its operating costs by job cuts and divestments, increasing its profit to 17.5 million euros from a loss of 21 million euros. A 12% increase in sales means that a company’s variable costs also increased, but if the company has fixed costs, it could increase operating leverage, leading to profits.
If a company has a low operating leverage, it should also have fixed costs to keep the operational costs at a minimum. With fixed costs, the operating costs are constant as sales increase. When a company’s sales increase while operating with a low operating leverage and fixed costs, the company might consider ways to increase sales, such as unique advertisements and promotions, as their operating income will increase (Warren, 2018). Decreasing variable costs such as machine maintenance (hiring a person to do multiple jobs) reduce variable costs; that is, if maintenance personnel are paid by the hour. Establishing contracts for maintenance operations can decrease the number of variable costs associated with unit production, thus cutting variable costs. Companies that operate using automated machines may have high operating leverage due to its fixed costs. In contrast, a company that operates using manual labor operates at a lower operating leverage as the employees may get paid by the hour (variable cost).
Warren, C.S. (2018). Survey of accounting (8th ed.). Retrieved from http://www.cengage.com
Post by classmate 2
Good Morning Class,
To better understand the situation that was presented we must first what operating leverage is and how there are two different types of operating leverage. Operating leverage is the measure of a company’s fixed costs as a percentage of the total costs. Operating leverage is split into two different categories: high and low operating leverage. High operating leverage is when a company’s costs is mostly made of fixed costs, while low operating leverage is when a company’s costs are mostly made of variable costs. High operating companies earn profit from increasing the amount of sales to ensure that they can cover the high costs. Low operating leverage companies earn a profit by having less quantitative sales, and generally performing higher quality leveled work (Bragg, S. 2018).
Therefore, if a company’s sales increases 12%, the earnings do not necessarily increase by 12%. This is because the company will be able to afford more costs, such as more advertising, higher quality training, etc. A company with a high operating leverage would likely welcome this increase in sales because it would likely lead to higher profit, while a company with low operating leverage may not be as interested in this, because it would mean that there are more variable costs, leading to less profit. Also changes in sales impact so much more than just earnings, so the changes in sales could lead to either much higher or lower earnings depending on what the budget of fixed and variable costs are.
Bragg, S. (2018, December 31). Operating leverage. Accounting Tools. https://www.accountingtools.com/articles/2017/5/13/operating-leverage (Links to an external site.)