Leverage

Leverage

Prof. Manas Mayur

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The Big Picture 

Magnified gain

The other side 

Magnified loss

What’s in between 

Cost which is fixed

Leverage 

The law of physics says, when a lever is used properly, a force applied at one point is transformed, or magnified, into another, larger force or motion at some other point

Weight Force a

b fulcru

Leverage 

In a business context, however, leverage refers to the use of fixed costs in an attempt to increase (or lever up) profitability or in other word magnify the potential return to a firm ◦ Operating leverage : The use of fixed operating costs by the firm ◦ Financial leverage: The use of fixed financing costs by the firm.

Objective 

To understand the break-even or the point at which a firm covers both fixed and variable costs.

By the end of this chapter 

You will understand ◦ ◦ ◦ ◦

Operating leverage Financial leverage Total leverage Combination of methods

Operating leverage 

Operating leverage is a measure of the extent to which, fixed operating costs are being used in an organization.



It is greatest (largest) in companies that have a high proportion of fixed operating costs in relation (proportion) to variable operating costs. This type of company is using more fixed assets in the operation of the company.



Conversely, operating leverage is lowest in companies that have a low proportion of fixed operating costs in relation to variable operating costs.

 

Operating leverage 

Fixed operating costs are unchanged over short periods of time regardless of sales activity. ◦ It includes expenses such as depreciation of buildings and equipment, rent, utilities, insurance, part of the cost of management.



Variable operating costs change with sales activities. ◦ Expenses include raw materials, advertising, sales commissions, credit card fees, and inventory financing costs.

Operating leverage EBIT Sales

Operating leverage

Each firm is expecting a 50 percent increase in sales for next year

Operating leverage

Break Even Analysis Consider a firm that produces a high quality child’s bicycle helmet that sells for $50 a unit.  Company has annual fixed costs of $100,000 and variable operating costs are $25 a unit regardless of the volume sold.  We want to study the relationship between total operating costs and total revenues 

Break Even Analysis Revenues and costs ($ thousands)

Total Revenue

Prof

Profit

250 Total costs

200 150

100

Variable costs Loss

Fixed costs

Loss

4,000

Units produced and sold (Q) Fixed costs ($100,000) Price ($50) Variable costs per

Mathematically EBIT = P(Q) – V (Q) – FC = Q(P – V) – FC Where EBIT = earnings before interest and taxes (operating profit) P = price per unit V = variable costs per unit Q = quantity (units) produced and sold FC = fixed costs

Mathematically 

At break even point, EBIT is zero 0 = QBE(P – V) – FC

Or,

QBE = FC / (P – V)

Thus,

QBE = $100,000/ ($50 - $25) = 4,000 units

Degree of Operating Leverage

Degree of operating Percentage change in Leverage (DOL) at Q = operating profit (EBIT) Units of output Percentage change in output (or Sales)

Next Class 

Financial Leverage



Total Leverage