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Small changes in a company's revenues can result in significant changes in its earnings or losses due to the concept of operating leverage. Operating leverage is a critical factor that affects a company's profitability and explains why changes in revenues don't directly correlate with changes in earnings. It occurs because the cost structure of a business is composed of both fixed and variable costs. Companies have two types of costs in their cost structure: fixed and variable. Fixed costs remain constant regardless of the level of sales or production. Examples include rent, depreciation, and salaries of permanent employees. Variable costs, on the other hand, change in proportion to the level of sales or production. These include direct labor, raw materials, and variable overhead. When a company has a high proportion of fixed costs in its cost structure, it is said to have high operating leverage. In this scenario, small changes in sales can have a magnified impact on earnings. For instance, if a company's sales increase by 12%, fixed costs remain constant, and the contribution margin (revenues minus variable costs) increases significantly. As a result, earnings can grow at a much faster rate than the increase in sales. This also means a company with high operating leverage is exposed to more risk. If sales decline, earnings can drop rapidly because fixed costs are still incurred, and there might need to be more revenue to cover them. This amplifies the effects of a downturn, and losses can mount quickly. Companies with a more balanced cost structure, with a higher proportion of variable costs, have lower operating leverage. This means that changes in sales have a more proportional impact on earnings. In such cases, a 12% increase in sales may result in a more closely correlated 12% increase in earnings, assuming variable costs increase proportionally.

References:

Investors take flight after Angry Birds maker warns on profit. (2018, February 22).Reuters. https://www.reuters.com/article/us-rovio-results/investors-take-flight-after-angry-birds-maker-warns-on-profit-idUSKCN1G60OB

Bragg, S. (2022).Operating leverage definition. AccountingTools. https://www.accountingtools.com/articles/operating-leverageLinks to an external site.