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Module 6 - Operating and Financial Leverage

This document provides an overview of operating and financial leverage. It defines key concepts like cost-volume-profit (CVP) analysis, break-even point, contribution margin, degree of operating leverage, and degree of financial leverage. It explains how CVP analysis can be used to determine the sales volume needed to break even or achieve a target profit level. The document also discusses the assumptions and limitations of CVP analysis and how operating and financial leverage work together to impact earnings.

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125 views

Module 6 - Operating and Financial Leverage

This document provides an overview of operating and financial leverage. It defines key concepts like cost-volume-profit (CVP) analysis, break-even point, contribution margin, degree of operating leverage, and degree of financial leverage. It explains how CVP analysis can be used to determine the sales volume needed to break even or achieve a target profit level. The document also discusses the assumptions and limitations of CVP analysis and how operating and financial leverage work together to impact earnings.

Uploaded by

emmanvillafuerte
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Module 6

Operating and
Financial Leverage
M. MANAYAO, CPA, MBA
Learning Objectives

Understand the Know how cost- Understand the


Explain the meaning
concept and volume-profit assumptions and
of operating
application of relationship is limitations of the CVP
leverage.
leverage in business. applied. analysis.

Calculate and Calculate and Explain the impact of


Understand the
interpret the firm’s interpret the firm’s combining operating
nature of financial
degree of operating degree of financial leverage and
leverage.
leverage. leverage. financial leverage.

M. Manayao, CPA, MBA


Leverage represents the use of
fixed costs items to magnify the
firm’s results. It is however,
important to keep in mind that
Introduction leverage is a two-edged sword –
producing highly favorable results
when things go well, and quite the
opposite under negative
conditions.

M. Manayao, CPA, MBA


Cost-Volume-Profit (CVP) 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:
CVP a. Selling prices
Analysis b. Sales volume
c. Unit variable costs
d. Total fixed costs

e. Mix of products sold

M. Manayao, CPA, MBA


CVP Analysis
This model is used to answer a variety
of critical questions such as:
• What is the company’s breakeven
volume?
• What is its margin of safety?
• What is likely to happen if specific
changes are made in prices, costs and
volume?

M. Manayao, CPA, MBA


CVP Analysis

Contribution Margin per Unit or


Marginal Income per Unit

Contribution Margin Ratio


Break-even
Point
Break-even point is the level of
sales volume where total revenues
and total expenses are equal, that
is, there is neither profit nor loss.
This point can be determined by
using CVP analysis. Break-even
point can be computed as follows:
Break-even sales for
Multi-products

Break-even sales for multi-


products firm (combined
units)

Weighted Contribution
Margin per Unit
Break-even sales for
Multi-products

Break-even sales for


multi-products firm
(combined pesos)

Weighted CM ratio
CVP
Analysis
for
Revenue CVP analysis can be used to determine the level of sales
needed to achieve a desired level of profit. In revenue
and Cost planning, CVP analysis assists managers in determining
the revenue required to achieve a desired profit level.
Planning
CVP Analysis constitutes a very
important tool for management
planning. Certain underlying
Assumptions assumptions upon which it rests,
however, place definite limitations on
and the conclusions which can be drawn
Limitations from its results. Whenever the
underlying assumptions of CVP
of CVP analysis do not correspond to a given
Analysis situation, the limitations, of the
analysis must be clearly recognized if
the break-even tool is to be useful and
educational.

M. Manayao, CPA, MBA


Assumptions and Limitations of CVP Analysis
In summary, the following static assumptions will limit the precision
and reliability of a given break-even analysis:

Assumption/Limitation Comment
The analysis is valid for a limited range of Failure to observe these limits would lead to
values – the “relevant” – and a limited working with unrealistic data.
period of time.
All costs can be categorized as fixed or Semi-variable costs present a problem that can be
variable. solved by segregating fixed and variable portion.
a. Variable costs change proportionately
with volume within the relevant volume
range.
b. Fixed costs are constant within the
relevant volume range.
Assumptions and Limitations of CVP Analysis
Assumption/Limitation Comment
Revenue change proportionately with Price is constant for all volumes within the
volumes with selling price remaining relevant range.
constant.
There is a constant product mix. Data should be adjusted for any shifts in product
mix.
Changes in volume alone are responsible There are other factors affecting costs and
for changes in costs and revenues. revenues, but they are lessened if narrow time and
volume limits are applied.
There is no significant change in Data should be adjusted if inventories change
inventories (i.e., in physical units, sales markedly.
volume equals production volume)
Operation leverage questions can be dealt This should be supposed supported with capital
with in the CVP framework. budgeting approaches that consider the time
value of money.
The analysis is deterministic and Uncertainly and a probabilities approach can be
appropriate data can be found. introduced.
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 greater amount of profits.
Most companies have many products, and
often these products are not equally
profitable. Hence, profits will depend to
some extent on the company’s sales mix.
Profits will be greater if high-margin rather
than low-margin items make up a relatively
large portion of total sales.
Operating leverage is a measure of how sensitive net operating
income is to a given percentage change in pesos 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.

Operating The degree of operating leverage at a given level of sales is


Leverage computed by the following formula:
The degree of operating leverage is a measure, at
a given level of sales, of how a percentage change
in sales volume will affect profits.

Degree of Operating Leverage (DOL) is also


Operating viewed as the percentage change in operating
income that occurs as a result of a percentage
Leverage change in units sold.
Having discussed the effect of fixed costs on the
operations of the firm (operating leverage), we now
turn to the second form of 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. you
Financial may have heard of the real estate developer who
borrows 100% of the costs of his project and will enjoy
Leverage an infinite return on his zero investment if all goes
well.

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.

M. Manayao, CPA, MBA


Financial Whereas operating leverage influences the mix of
plant and equipment, financial leverage
Leverage determines how the operation is to be financed. It
is possible for two firms to have equal operating
capabilities and yet show widely different results
because of the use of financial leverage.
Financial
Leverage
The degree of financial leverage measures the
effect of a change in one variable to another
variable. Degree of Financial Leverage (DFL)
may be defined as the percentage change in
earnings (EPS) that occurs as a result of a
percentage change in earnings before interest
and taxes (EBIT).

For purposes of computation, the formula for


DFL may be conveniently restated as:
Degree of Combined Leverage (DCL) use the entire income
statement shows the impact of a change in sales or volume
Combining on bottom-line earnings per share. Degree of operating and
financial leverage is in effect, being combined.

Operating
The formula for degree of combined leverage is stated as:
and
Financial
Leverage
Problem 1 (page 178)
Requirement a
Sales 200,000
Less: Variable expenses (120,000)
Contribution margin 80,000
CM Ratio = 80,000 / 200,000 = 40%
Requirement b
1,000 x 40% = 400 + 15,000 = 15,400
Problem 3 (page 179)
Requirement 1
Sales (1,000 x 30) 30,000
Less: BEP (750 x 30) (22,500)
Margin of Safety 7,500
BEP = 7,500 / 10 = 750
Requirement 2
7,500 / 30,000 = 25%
Problem 4 (page 179)
Requirement 1
DOL = Contribution Margin / Net Operating Income
DOL = 48,000 / 10,000 = 4.8x

Requirement 2
5% x 4.8 = 24%
Problem 4 (page 179)
Requirement 3
Sales (80,000 x 1.05) 84,000
Less: Variable expenses (32,000 x 1.05) (33,600)
Contribution margin 50,400
Less: Fixed expenses (38,000)
Net Operating Income 12,400
(12,400 – 10,000) / 10,000 = 24%
Problem 10 (page 182)
Requirement a
DOL = Q (P – VC) / Q (P – VC) – FC
DOL = 20,000 (60 – 30)/ 20,000 (60-30) – 400,000
DOL = 20,000 x 30 / (20,000 x 30) – 400,000
DOL = 600,000 / 600,000 – 400,000
DOL = 600,000 / 200,000
DOL = 3x
DOL = 600,000 / 200,000 = 3x
Problem 10 (page 182)
Requirement b
DFL = EBIT / (EBIT – i)
DFL = 200,000 / (200,000 – 50,000)
DFL = 200,000 / 150,000
DFL = 1.33x
Problem 10 (page 182)
Requirement c
DCL = Q (P – VC) / Q (P – VC) – FC – i
DCL = 20,000 (60 – 30) / 20,000 (60 – 30) – 400,000 –
50,000
DCL = 20,000 x 30 / (20,000 x 30) – 400,000 – 50,000
DCL = 600,000 / (600,000 – 400,000 – 50,000)
DCL = 600,000 / 150,000
DCL = 4x
Problem 10 (page 182)
Requirement d
BEP = Fixed costs / CM per unit
BEP = 400,000 / 30
BEP = 13,333 units
➢QUESTIONS????
➢REACTIONS!!!!!
END

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