Question

Which of the following companies would you expect to have the highest operating leverage number and which would have the lowest? Be sure to explain your choices.

Amazon

Intel

Walmart

Answer 1

Operating leverage :

Operating leverage is the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating leverage. The higher the degree of operating leverage, the greater the potential danger from forecasting risk, where a relatively small error in forecasting sales can be magnified into large errors in cash flow projections.

Operating leverage measures a company's fixed costs as a percentage of its total costs. It is used to evaluate the breakeven point of a business, as well as the likely profit levels on individual sales.

According to my expectation among the three companies Amazon is having highest operating leverage.

and below is my analysis regarding it.

DOL formula = % change in EBIT / % change in Sales

DOL OF AMAZON – 2016

• % change in EBIT (2016) = (4,186-2,233)/2,233 = 87%
• % change in Sales (2016) = (135,987 – 107,006)/107,006 = 27%
• Amazon’s DOL (2016) = 87% / 27% = 3.27x

DOL OF AMAZON – 2015

• % change in EBIT (2015) = (2,233- 178)/174 = 1154%
• % change in Sales (2015) = (107,006 – 88,988)/88,988 = 20%
• Amazon’s DOL (2015) = 1154% / 20% = 57.02x

We can say that Amazon is having

• Higher Fixed Costs
• Lower Variable Costs

Walmart retail stores have low fixed costs and large variable costs, especially for merchandise. Therefore, Walmart stores have low operating leverage.

Coming to the point of view of Intel:

Companies which produces computer processors like Nec, Intel, tend to make large investments in production facilities and equipment and therefore have a cost structure with high fixed costs.

So these companies will attain high operating leverage.

Intel operating margin was noted at 30.30%. The company maintained a Gross Margin of 61.90%. The Institutional ownership of the firm is 68.70% while Insiders ownership is 0.04%. Company has kept return on investment (ROI) at 12.40% over the previous 12 months and has been able to maintain return on asset (ROA) at 10.50% for the last twelve months. Return on equity (ROE) recorded at 19.00%.

Finally operating leverage is key to compare among companies in the same industry, as some industries have higher fixed costs than others.