Operating leverage can tell investors a lot about a company’s risk profile, and although high operating leverage can often benefit companies, firms with high operating leverage are also vulnerable to sharp economic and business cycle swings.
In good times, high operating leverage can supercharge profit. But companies with a lot of costs tied up in machinery, plants, real estate and distribution networks cannot easily cut expenses to adjust to a change in demand. So, if there is a downturn in the economy, earnings do not just fall, they can plummet.
Consider the software developer Inktomi. During the 1990s investors marvelled at the nature of its software business. The company spent tens of millions of dollars to develop each of its digital delivery and storage software programs. But thanks to the internet, Inktomi’s software could be distributed to customers at almost no cost. In other words, the company had close to zero cost of goods sold.
After its fixed development costs were recovered, each additional sale was almost pure profit.
After the collapse of dotcom technology market demand in 2000, Inktomi suffered the dark side of operating leverage. As sales took a nosedive, profits swung dramatically to a staggering \($58\) million loss in a single quarter – plunging down from the \($1\) million profit the company had enjoyed in Q1 of the previous year. The high leverage involved in counting on sales to repay fixed costs can put companies and their shareholders at risk. High operating leverage during a downturn (such as the recession following the 2008 financial crisis) can be an Achilles heel, putting pressure on profit margins and making a contraction in earnings unavoidable.
Indeed, companies such as Inktomi with high operating leverage typically have larger volatility in their operating earnings and share prices. As a result, investors need to treat these companies with caution.
Question:
1 Provide examples of other companies that have high and low degrees of operating leverage.