Question

Business Applications  Operating leverage: Description of business for Caterpillar, Inc.

With 2014 sales and revenues of $55.184 billion, Caterpillar is the world’s leading manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. The company principally operates through its three product segments—Resource Industries, Construction Industries, and Energy & Transportation (formerly Power Systems)—and also provides financing and related services through its Financial Products segment. Caterpillar is also a leading U.S. exporter.

Description of business for the Kroger Company from its Form 10-K:

The Kroger Co. was founded in 1883 and incorporated in 1902. As of January 31, 2015, we are one of the largest retailers in the nation based on annual sales. . . .

As of January 31, 2015, Kroger operated, either directly or through its subsidiaries, 2,625 supermarkets and multi-department stores, 1,330 of which had fuel centers. Approximately 48% of these supermarkets were operated in Company-owned facilities, including some Company-owned buildings on leased land. Our current strategy emphasizes self-development and ownership of store real estate. Our stores operate under several banners that have strong local ties and brand recognition. Supermarkets are generally operated under one of the following formats: combination food and drug stores (“combo stores”); multi-department stores; marketplace stores; or price impact warehouses.

Required

1. Determine which company appears to have the higher operating leverage.
2. Write a paragraph or two explaining why the company you identified in Requirement a might be expected to have the higher operating leverage.
3. If revenues for both companies increased by 5 percent, which company do you think would likely experience the greater percentage increase in operating earnings? Explain your answer

Answer 1

a. Caterpillar Inc. appears to have the higher operating leverage.

b.. Operating leverage occurs because of fixed operating costs like rent, depreciation etc.

For Caterpillar Inc, the percentage decrease in revenue from 2013 to 2014 was 0.84 %. But the percentage decrease in operating earnings was far higher at 5.33 %, i.e nearly 6.35 times the increase in revenues.

On the other hand, for Kroger Co., year-on-year percentage increase in revenue = 10.26 %.

Year-on year percentage increase in operating earnings is only 15.12 %, i.e only 1.47 times the increase in revenues.

Therefore, it is clear that Caterpillar Inc. has the higher operating leverage between the two companies.

c. If revenues for Caterpillar Inc., increased by 5%, operating earnings would increase by 5 % x 6.35 = 31.75 %.

If revenues for Kroger Co. increased by 5%, operating earnings would increase by only 5 % x 1.47 = 7.35 %