Operating and Financial Leverage

OPERATING AND FINANCIAL
LEVERAGE
INTRODUCTION
Leverage represents the use of fixed costs items to magnify the firm’s results. It is however,
important to keep in mind that leverage is a two- edged sword– producing highly favorable results
when things go well, and quite the opposite under negative conditions.
CVP ANALYSIS
Cost- volume- profit analysis is a powerful tool and vital in many business decisions because it helps
managers understand the relationships among cost, volume and profit. CVP analysis focused on how
profits are affected by the following elements:
a. Selling Prices
b. Sales Volume
c. Unit Variable Costs
d. Total Fixed Costs
e. Mixed of Product Sold.
This model is used to answer a variety of critical questions such as:
1. What is the company’s breakeven volume?
2. What is its margin of safety?
3. What is likely to happen if specific changes are made in prices, costs and volume?
The following relationships may be established:
Contribution Margin per unit or marginal income per unit
This is the excess of unit selling price over unit variable costs and the amount each unit sold
contributes toward
1. Covering Fixed Costs and
2. Providing Operating Profits.
Formula:
CM Per Unit = Unit Selling Price – Unit Variable Costs
Contribution Margin Ratio
This is the percentage of contribution margin to total sales. This ratio is computed as follows:
CM Ratio = Contribution Margin / Sales
CVP ANALYSIS FOR BREAKEVEN PLANNING
Breakeven point is the level of sales volume where total revenues and total expenses are equal, that
is, there is neither profit or loss. This point can be determined by using CVP Analysis. Breakeven
point can be computed as follows:
1. BEP (Units) = Total Fixed Costs/ Contribution Margin per Unit
2. BEP (Pesos) = Total Fixed Costs/ CM Ratio
3. a. BEP Sales for multi- products firm (Combined Units) = Total Fixed Costs / Weighted Average
Contribution Margin
b. Weighted Contribution Margin per unit = (Unit CM x No. of units per Mix + Unit CM x No. of
units per mix) / Total number of units per Sales Mix
4. a. BEP Sales for multi- products firm (combined pesos) = Total Fixed Costs / Weighted
Contribution Margin Ratio
b. Weighted CM Ratio = Total Weighted CM / Total Weighted Sales
CVP ANALYSIS FOR REVENUE AND COST
PLANNING
CVP Analysis can be used to determine the level of sales needed to achieve a desired level of
profit. In revenue planning, CVP analysis assists managers in determining the revenue required to
achieve a desired profit level. The equation that may be used to compute for target sales follows:
Sales (Units) = Total Fixed Costs + Desired Profit / Contribution Margin per Unit
Sales (Pesos) = Total Fixed Costs + Desired Profit / Contribution Margin Ratio
ASSUMPTIONS AND LIMITATIONS OF CVP
ANALYSIS
1. The analysis is valid for a limited range of values- the “relevant” – and a limited period of
time.
2. All costs can be categorized as fixed or variable.
a. Variable costs change proportionately with volume within the relevant volume range.
b. Fixed costs are constant within the relevant volume range.
3. Revenues change proportionately with volumes with selling price remaining constant.
4. There is a constant product mix.
5. Changes in volume alone are responsible for changes in costs and revenues.
6. There is no significant change in inventories (i.e., in physical units, sales volume equals
production volume.)
7. Operation leverage questions can be dealt with in the CVP framework.
8. The analysis is deterministic and appropriate data can be found.
SALES MIX
Sales mix refers to the relative proportions in which a company’s products are sold. The idea is to
achieve the combination, or mix that will yield the greatest amount of profits. Most companies
have many products, and often these products are not equally profitable. Hence, profit will depend
to some extent on the company’s sales mix. Profits will be greater if high- margin rather that low-
margin items make up a relatively large proportion of total sales.
OPERATING LEVERAGE
Operating leverage is a measure of how sensitive net operating income is to a given percentage
change in peso sales. Operating leverage acts as a multiplier. If operating leverage is high, a small
percentage increase in sales can produce a much larger percentage increase in net operating
income.
DEGREE OF OPERATING LEVERAGE
The degree of operating leverage at a given level of sales is computed by the formula:
Degree of Operating leverage = Contribution Margin / Net Operating Income
ALTERNATIVE APPROACH
Degree of Operating Leverage (DOL) is also viewed as the percentage change in operating income
that occurs as a result of a percentage change in units sold.
Degree of operating leverage = Percentage change in operating income / Percentage change in unit
volume
FINANCIAL LEVERAGE
Financial leverage reflects the amount of debt used in the capital structure of the firm. Because debt
carries a fixed obligation of interest payments, we have the opportunity to greatly magnify our
results at various levels of operations.
It is helpful to think of operating leverage as primarily affecting the left- hand side of the statement
of financial position and financial leverage as affecting the right- hand side.
COMBINING OPERATING AND FINANCIAL
LEVERAGE
Degree of combined leverage (DCL) use the entire income statement shows the impact of a change
in sales or volume on bottom- line earnings per share.
DCL = Percentage change in EPS / Percentage Change in Sales (or Volume)

Operating and Financial Leverage

Uploaded by

Copyright:

Available Formats

Operating and Financial Leverage

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Operating and Financial Leverage

Uploaded by

Copyright:

Available Formats

OPERATING AND FINANCIAL

You might also like