Final answer:
Firms with a high degree of operating leverage have a higher proportion of fixed costs compared to variable costs in their cost structure, making them more sensitive to changes in sales volume. This can lead to higher profits when sales increase, but also larger losses when sales decline. Firms with high operating leverage should carefully manage their fixed costs and monitor their sales volume to mitigate risks.
Step-by-step explanation:
Firms that have a high degree of operating leverage are the ones that have a higher proportion of fixed costs compared to variable costs in their cost structure. Operating leverage measures the sensitivity of a firm's profits to changes in sales volume. It is calculated by dividing the contribution margin (sales minus variable costs) by the operating income (profit before interest and taxes) of the firm. Firms with high operating leverage are more sensitive to changes in sales, meaning that a small change in sales can have a significant impact on their profits.
For example, let's say a firm has $1,000,000 in sales and $800,000 in fixed costs and variable costs of $100,000. The contribution margin would be $900,000 ($1,000,000 - $100,000) and the operating income would be $100,000 ($900,000 - $800,000). The operating leverage would be 9 ($900,000 / $100,000), indicating that a 1% change in sales would result in a 9% change in operating income.
High operating leverage can be beneficial for firms when sales are increasing, as it can lead to higher profits. However, it can also be risky when sales are declining, as it can result in larger losses. Therefore, firms with high operating leverage should carefully manage their fixed costs and monitor their sales volume to mitigate the risks associated with operating leverage.