Which of the following statements about Operating Leverage and Risk from the lecture are TRUE:Someone with relatively high fixed costs and low variable costs will have a high level of operating leverage and a low risk of making a large loss if their income falls.Someone with relatively low fixed costs and high variable costs will have a low level of operating leverage and a high risk of making a large loss if their income falls
Question
Which of the following statements about Operating Leverage and Risk from the lecture are TRUE:Someone with relatively high fixed costs and low variable costs will have a high level of operating leverage and a low risk of making a large loss if their income falls.Someone with relatively low fixed costs and high variable costs will have a low level of operating leverage and a high risk of making a large loss if their income falls
Solution
The first statement is partially correct. Someone with relatively high fixed costs and low variable costs will indeed have a high level of operating leverage. This is because fixed costs are costs that have to be paid regardless of the level of output, while variable costs change with the level of output. Therefore, a business with high fixed costs and low variable costs will have a high operating leverage because a large portion of their costs are fixed and do not decrease when output decreases.
However, this also means that they have a high risk of making a large loss if their income falls, not a low risk as the statement suggests. This is because their high fixed costs have to be paid regardless of their income level. If their income falls, they may not be able to cover these fixed costs, leading to a large loss.
The second statement is also partially correct. Someone with relatively low fixed costs and high variable costs will have a low level of operating leverage. This is because their costs are largely variable and will decrease when output decreases.
However, this does not necessarily mean they have a high risk of making a large loss if their income falls. In fact, they may have a lower risk compared to someone with high fixed costs. This is because their costs will decrease when their income falls, potentially offsetting some of the loss in income. Therefore, they may be better able to manage a fall in income without making a large loss.
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