Final answer:
High operating leverage is beneficial for a company when sales are increasing, as it amplifies profit growth. On the flip side, when sales decline, high operating leverage can lead to rapid profit decreases due to high fixed costs. Operating leverage is a critical factor in determining a firm's profitability in changing sales conditions.
Step-by-step explanation:
When a company's sales revenue is increasing, high operating leverage is good because it means that profits will increase. However, when sales are declining, too much operating leverage will cause profit to decline.
Operating leverage is a measure that assesses the proportion of fixed costs in a company's cost structure. A high degree of operating leverage means that a large amount of fixed costs require a high volume of sales to break even, but once that level is passed, additional sales result in higher profits. This is advantageous when a company's sales are on the rise.
Conversely, when sales are decreasing, a company with high operating leverage will face a rapid decline in profits. High operating leverage means fixed costs remain constant despite falling sales, which could quickly lead to losses. These fixed costs amplify the impact of decreasing sales on the bottom line.
Therefore, firms with high operating leverage benefit from a rising sales environment as profits increase, but they also risk substantial profit declines if sales start to fall.