Operating Leverage Essay

Operating leverage Def. of leverage – The degree to which an investor or business is utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Leverage is not always bad, however; it can increase the shareholders’ return on investment and often there are tax advantages associated with borrowing. Def of operating leverage- a measurement of the degree to which a firm or project incurs a combination of fixed and variable costs. 1.

A business that makes few sales, with each sale providing a very high gross margin, is said to be highly leveraged. A business that makes many sales, with each sale contributing a very slight margin, is said to be less leveraged. As the volume of sales in a business increases, each new sale contributes less to fixed costs and more to profitability. 2. A business that has a higher proportion of fixed costs and a lower proportion of variable costs is said to have used more operating leverage. Those businesses with lower fixed costs and higher variable costs are said to employ less operating leverage. xplains ‘Operating Leverage’ The higher the degree of operating leverage, the greater the potential danger from forecasting risk. That is, if a relatively small error is made in forecasting sales, it can be magnified into large errors in cash flow projections. The opposite is true for businesses that are less leveraged. A business that sells millions of products a year, with each contributing slightly to paying for fixed costs, is not as dependent on each individual sale. For example, convenience stores are significantly less leveraged than high-end car dealership

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How It Works/Example: Here is the formula for operating leverage: Operating Leverage = [Quantity x (Price – Variable Cost per Unit)] / Quantity x (Price – Variable Cost per Unit) – Fixed Operating Cost To see how operating leverage works, let’s assume Company XYZ sold 1,000,000 widgets for $12 each. It has $10,000,000 offixed costs (equipment, salaried personnel, etc. ). It only costs $0. 10 per unit to make each widget. Using this information and the formula above, we can calculate that Company XYZ’s operating leverage is: Operating Leverage = [1,000,000 x ($12 – $0. 0)] / 1,000,000 x ($12 – $0. 10) – $10,000,000 = $11,900,000/$1,900,000 = 6. 26 or 626% ————————————————- This means that a 10% increase in revenues should yield a 62. 6% increase in operating income (10% * 6. Leverage ————————————————- Def. Degree of Operating Leverage Operating leverage results from the presence of fixed operating costs in a firm’s income stream. The extent of the presence of fixed operating costs in a firm’s income stream is measured by the degree of operating leverage (DOL).

DOL =| Percentage Change in Earnings Before Interest and Taxes (EBIT)|  | | Percentage Change in Sales| | Financial leverage results from the presence of fixed financial costs in a firm’s income stream. The extent of the presence of fixed financial costs in a firm’s income stream is measured by the degree of financial leverage (DFL). DFL =| Percentage Change in Net Income (NI)|  | | Percentage Change in Earnings Before Interest and Taxes (EBIT)| | Firm’s often have both operating and financial leverage.

This total or combined leverage results from the presence of both fixed operating and financial costs in a firm’s income stream. Combined leverage is measured by the degree of combined leverage (DCL). DCL =| Percentage Change in Net Income (NI)|  | | Percentage Change in Sales| | Notice that DCL = DFL ? DOL ————————————————- Degree of Leverage Firms that have greater degrees of leverage have greater levels of fixed costs. And as such, they tend to have greater break-even points than do firm’s that do not have leverage.

The advantage of having greater degrees of leverage is that as a firm’s sales volume increases beyond the break-even point, its margins improve. The disadvantage of having greater degrees of leverage is that because the break-even point is higher, which means that the firm is required to achieve a higher sales volume in order to reach the break-even point. In good times when sales are high, a higher degree of leverage allows a firm to maximize profits. In bad times when sales are not as good, the firm is able to minimize its losses by having a lower degree of leverage.

Example: In the example below, a firm’s projected EBIT under two very different cost structures. Income Statement| High Leverage| Low Leverage| Sales| $| 100,000|  | 100| %| $| 100,000|  | 100| %| Variable Operating Costs|  | -20,000|  | -20|  |  | -40,000|  | -40|  | Contribution Margin|  | 80,000|  | 80|  |  | 60,000|  | 60|  | Fixed Operating Costs|  | -40,000|  | -40|  |  | -20,000|  | -20|  | EBIT| $| 40,000|  | 40| %| $| 40,000|  | 40| %| Notice the firm experiences the same level of sales, while it has very different cost structures.

Now notice what happens to the firm under each option when their sales decrease to $50,000. Income Statement| High Leverage| Low Leverage| Sales| $| 50,000|  | 100| %| $| 50,000|  | 100| %| Variable Operating Costs|  | -10,000|  | -20|  |  | -20,000|  | -40|  | Contribution Margin|  | 40,000|  | 80|  |  | 30,000|  | 60|  | Fixed Operating Costs|  | -40,000|  | -80|  |  | -20,000|  | -40|  | EBIT| $| 0|  | 0| %| $| 10,000|  | 20| %|

When the sales drop to $50,000, the high leverage option declines to its break-even point while the low leverage option minimizes the loss. Now notice what happens to the firm’s sales increase to $150,000. Income Statement| High Leverage| Low Leverage| Sales| $| 150,000|  | 100| %| $| 150,000|  | 100| %| Variable Operating Costs|  | -30,000|  | -20|  |  | -60,000|  | -40|  | Contribution Margin|  | 120,000|  | 80|  |  | 90,000|  | 60|  | Fixed Operating Costs|  | -40,000|  | -27|  |  | -20,000|  | -13| EBIT| $| 80,000|  | 53| %| $| 70,000|  | 47| %| When a firm’s sales increase, the cost structure option with the higher degree of leverage is able to maximize the firm’s profits. 26). Adavntage of degree of operating leverage * Helps in designg apporpriste capital structure of firm * Indicate market price of the share * Enable understand how eps would change given in certain change in ebit