CHAPTER 14 OPERATING AND FINANCIAL LEVERAGE

LEVERAGE – represents the use of fixed costs items to magnify the firm’s results.

LEVERAGE IN BUSINESS
two primary decisions :
* You must determine the amount of fixed cost plant and equipment you wish to use in then
production process.
* You must determine how will you finance the business.
CVP ANALYSIS (COST-VOLUME-PROFIT)
- Is a powerful tool and vital in many business decisions because it helps managers understand
the relationships among cost, volume and profit.
- focused on how the profits are affected by the following elements:
a) selling prices
b) sales volume
c) unit variables costs
d) total fixed costs and
e) mix of products sold
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
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 BREAKING PLANNING

Break-even point - is the level of sales volume where total revenues and total expenses are equal ,
there is profit or loss.

Break-even point (units) = Total Fixed Costs

Contribution Marginal per unit
Break-even point (peso) = Total Fixed Costs
Variable Costs
Sales
3)
a) Break-even sales for
multi-products firm = Total Fixed Cost
(Combined Units) Weighted Average Contribution Margin

b) Weighted Contribution
Margin per unit

Unit CM x No. of units Unit CM x No. of units

per mix + per mix
Total number of units per Sales Mix

4)
a) Break-even sales for multi-products firm = Total Fixed Costs
( combined pesos) Weighted CM ratio

b) Weighted CM ratio = Total Weighted CM (P) Total

Weighted Sales (P)

1. Mr. Chua own a toy shop and want to figure out his break-even point in units , His fixed costs
per month is P4,500, Variable costs is P 10 and his sales per toy is P 20.
Compute for the contribution margin and break-even point in units.
SOLUTION ; CM per unit = unit selling price - unit variable costs =
20 - 10 = 10 Break-even point = Total fixed costs ( in units )
CM per unit = 4,500 10
= 450
CVP ANALYSIS FOR REVENUE AND COST PLANNING
- used to determine the level of sales needed to achieve a desired level of profit.
The equation that may be used to compute for target sales follows.

sales ( units ) = Total fixed costs + Desired profit

Contribution Margin per unit
or
sales ( units) = Total fixed costs +Desired profit
Contribution Margin Ratio

Following are the assumptions of CVP ANALYSIS:No. of units - Only driver for costs and
revenues - it assumes that the total variable costs and revenues would increase or decrease
only due to a change in no. of units. Costs – Either Variable or fixed - This assumption says that
all the costs are either variable or fixed No Change in price, variable costs , and fixed costs -
CVP analysis assumes that there are no changes in the price and variable cost per unit irrespective
of change in time period and relevant range

Sales Mix (Lopez, Angelica)

- refers to the relative proportions in which a company’s products are sold.
 - is to achieve the combination, or mix that will yield the greatest amount of profits.
- changes in sales mix can cause perplexing variation’s in a company profits.

Cvp analysis for a multi-products firm

1. Lor, Inc. produces only two products, A and B. These account for 60% and 40% of the total
sales pesos of Lor’s respectively. Variable costs as a percentage of sales pesos are 60% for A and
85% for B. Total fixed costs are P150,000. There are no other costs.
Required:
Compute the weighted contribution margin ratio
Compute the break-even point in sales pesos.
Compute the sales pesos necessary to generate a net income of P9,000 if total fixed costs will
increase by 130%

Solution:
A B
1. Sales mix ratio 60% 40% Multiplied by :
Contribution margin ratio 40% 15% Weighted Contribution margin ratio
24% + 6% = 30%
2. Break-even Point (P) = Fixed costs Weighted CMR
= P150,000 30%
= P500,000

3. Desired net income P 9.000 Add; Total Fixed Costs ( P150,000 X

130%) 195,000 Contribution Margin P 204,000 Divided by: Weighted
CMR 30% Sales necessary to generate desired net income P680,000

Operating Leverage
- is a measure of how sensitive net operating income is to a given percentage change in
peso sales. - acts as a multiplier
Degree of operating leverage
FORMULA ;

Degree of operating leverage = Contibution margin

Net operating Income

The degree of operating leverage for two farms at P100,000 sales would be computed as follows:
Green Farm P40,000 = 4 Yellow Farm P70,000 = 7
P10,000 P10,000
Percent Increase Degree of operating Percent Increase in net
in sales leverage Operating Income
(1) (2) (1) x (2)
Green Farm 10% 4 40%
Yellow Farm 10% 7 70%
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 = Percent change in operating income

Percent change in unit volume

ILLUTRATIVE CASE OPERATING LEVERAGE/CVP RELATIONSHIP

Voltar Company manufactures and sells a specialized cordless telephone for high
electromagnetic radiation environments. The company’s contribution format income statement for
the most recent years is given below.

Total Per unit Percent of sales

Sales(20,000 units) P1,200,000 P60% 100%Variable
Expenses 90,000 45 ?Contribution Margin
300,000 P15 ?Fixed Expenses 240,000Net
Operating Income P 60,000
1 . Compute the company’s CM ratio and variable expense ratio ?
CM ratio = Unit contribution margin Variable expense = Variable expense
Unit selling price ratio selling price = 15
= 45 60 60
= 25 % = 75%

Assume that the sales increase by P 400,000 next year. I f the cost behavior patterns remain
unchanged, by how much will the company’s net operating income increase?Solution :
Increase in sales P400,000 Multiply by the CM ratio
x25% Expected increase in contribution margin P100,000

Assume that next year management wants the company to earn a profit of at least P90,000. How
many units will have to be sold to meet this target profit? Formula method :
Unit sales Target profit + P90,000 +to attain = fixed
expenses = P240,000 = 22,000 units the target profit Contribution
margin P15 per per unit unit

Compute the company’s margin of safety in both peso and percentage form. Margin of safety in
pesos = Total sales - Break even sales =
P1,200,000 - P960,000 = P240,000Margin of safety
percentage = Margin of safety in pesos = P240,000 = 20%
total sales P1,200,000

Financial leverage (Janine Fajardo)

Reflects the amount of debt used in the capital structures of the firm.
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.

Statement of Financial Position

ASSET LIABILITIES AND OWNER’S EQUITY
Operating Leverage Financial Leverage

IMPACT ON EARNINGS
we shall examine two financial plans for a firm, each employing a significantly different
amount of debt in the capital structure. Financing totaling P200,000 is required to carry the assets
of the firm.

TOTAL ASSETS – P200,000 Plan A

Plan B (Leveraged) (Conservative)Debt ( 8% P150,000
(P12,000 interest) P50,000(P4,000 interest) interest)Common (8,000 shares at
(24,000 shares at stock 50,000 P6.25) 150,000 P6.25)Total
Financing P 200,000 P200,000

Degree of financial leverage

It measure the effect of a change in one variable to another variable.
It may be also defined as the percentage change in earnings (EPS) that occurs as a result of a
percentage change in earnings before interest and taxes (EBIT)

Degree of financial leverage = Percent Change in EPS

Percent change in EBIT

for purposes of computation, the formula for DFL may be conveniently restated as:

Degree of financial leverage = Percent change in EPS

Percent change in EBIT lets compute the degree of financial leverage for Plan A and Plan B at an
EBIT level of P 36,000. Plan A calls for P 12,000 of interest at all levels of financing, and Plan B
requires P4,000.

Plan A ( Leveraged) DFL = EBIT = P36,000 = P36,000 = 1.5

EBIT – 1 P36,000 – P12,000 P24,000
Plan B (Conservative) DFL = EBIT = P36,000 = P36,000
=1.1 EBIT – 1 P36,000 – P4,000 P32,000

LIMITATIONS TO USE OF FINANCIAL LEVERAGE

We may quickly observe that if debt such a good thing, why sell any stock? With exclusive debt
financing at an EBIT level of P 36,000, we would have agree of financial leverage factor
(DFL) of 1.8.
DFL = EBIT = P36,000 = P36,000 = 1.8 EBIT
–1 P 36,000 – P16,000 P20,000 With no stock , we would borrow the full P200,000.
(8% X P200,000 = P16,000 interest )

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. Degree of operating and
financial leverage is in effect, being combined. Degree of combined leverage (DCL) =
Percent change in EPS Percent change in sales ( or
volume )

Sales (P2 per unit x 80,000 units) P160,000 P200,000 less: fixed costs
60,000 60,000 variable costs (P 0.80 per unit) 64,000 80,000
Operating income (EBIT) 36,000 60,000 less: Interest
12,000 12,000 Earnings before taxes 24,000 48,000
less: Taxes 12,000 24,000 Earnings after taxes
P12,000 P24,000 Shares 8,000
8,000 Earnings per share P 1.50 P 3.00