Companies often use leverage to augment profits. Based on what you learned this week, please explain the following in detail:

• With regards to Operating Leverage, please explain why a company with HIGH Operating Leverage faces greater financial risk in a declining sales period compared to a company with LOW Operating Leverage. (HINT: The key here is the relation between fixed costs and variable costs.)
• What does a business's Contribution Margin represent? What does the Contribution Margin have to do with Operating Leverage?

BELOW IS THE POST I NEED TO REPLY TO!!!

1. Operating Leverage and Financial Risk in Declining Sales Periods:

Operating leverage refers to how much a company uses fixed costs in its cost structure. A company with high operating leverage has more fixed costs than variable ones. In comparison, a company with low operating leverage has more variable costs than fixed costs.

High Operating Leverage: When sales decline, a company with high operating leverage still incurs the exact high fixed costs. This means that even if revenue decreases, the fixed costs remain constant, which can significantly reduce profitability. The financial risk is higher because the company must cover these fixed costs regardless of sales volume. As sales continue to drop, the contribution from each sale is not enough to cover the fixed costs, leading to a steep decline in operating income.

Low Operating Leverage: Conversely, a company with low operating leverage has lower fixed and variable costs. In this case, when sales decline, the variable costs decrease proportionally with the decline in sales, which helps to cushion the impact on profitability. The company is more flexible and can adjust its costs more efficiently, leading to lower financial risk during periods of declining sales.

2. Contribution Margin and Operating Leverage:

Contribution Margin: The contribution margin is the difference between sales revenue and variable costs. It represents the revenue available to cover fixed costs and contribute to profit. The formula for the contribution margin is:

• ContributionMargin=SalesRevenueVariableCosts

It can also be expressed on a per-unit basis:

• ContributionMarginperUnit=SellingPriceperUnitVariableCostperUnit

The contribution margin is crucial because it shows how much each sales dollar contributes to covering fixed costs after paying variable costs.

Relation to Operating Leverage: The contribution margin is directly related to operating leverage. A company with high operating leverage typically has a high contribution margin because its variable costs are low relative to sales. This means that each additional sale generates a significant contribution to covering fixed costs. However, in a declining sales environment, this same high contribution margin cannot compensate for the high fixed costs, leading to increased financial risk.

A company with high operating leverage faces greater financial risk during declining sales periods because it has high fixed costs that must be covered, regardless of sales volume. The contribution margin helps understand how much revenue is available to cover those fixed costs. In companies with high operating leverage, the pressure is higher to maintain sales levels to avoid substantial losses.