Operating and Financial Leverage

■Types of cost
■What is Leverage?
■Types of Leverage
■Operating Leverage
■Financial Leverage
■Graphical presentation
■EBIT-EPS Analysis
■Degree of Operating Leverage
■Degree of Financial Leverage
■Degree of Combined Leverage
 Types of Costs
■ There are two types of costs that a business faces:
■ Variable costs which vary proportionally with sales

■ Hourly wages

■ Utility costs

■ Raw materials

■ etc.

■ Fixed costs which are constant over a relevant range of

sales
■ Lease payments

■ Depreciation (based on the method)

■ etc.
 What is Leverage?
■ Leverage is using fixed costs to magnify the
potential return to a firm

■ 2 types of fixed costs:

■ fixed operating costs = depreciation
■ fixed financial costs= interest costs from
debt
 Types of Leverage

■ There are two types of Leverage

1) Operating Leverage
2) Financial Leverage
 Operating Leverage

■ Measure of the amount of fixed operating

costs used by a firm
■ The leverage associated with investment
(assets acquisition) activities is referred to
as operating leverage.
 Financial Leverage

■ Financial leverage is a measure of the

amount of the debt used by the firm.
■ The leverage associated with
Financing activities is referred to as
financial leverage.
 Break-even

■ Break-even is the point where total revenue equals

total cost.

■ Where VC is total variable costs, FC is total fixed

 Break Even Point

Fixe cost Fixed

BE = =
d
Contributio s margi
on Unit - Variabl costs
cost per uni
n n p e t
Fixed Cost
Price per unit – Variable cost per unit
 Break-even in Units
● We can find the operating break-even point in
units by simply solving for Q: We can also
write Q as BE ( that is break even)
 Break Even Point: An example

■ Suppose that a company has fixed costs of $100,000

and variable costs of $5 per unit. What is the
break-even point if the selling price is $10 per unit?
 Break Even Point: An example
■ Unit = 50,000
■ Total Variable cost= 50000*.80=40000
■ Fixed Cost= 60000
■ Total Cost= 100,000
■ Total Revenue= 50000*2=100,000

■ Find the break even point?

 Break Even Point: An example
■ BE= Fixed cost
Contribution margin

= Fixed cost____________
Selling price per unit- variable cost per unit

= 60000
2.00-.80
Graphical presentation of break even point
 Break Even Sales Unit
SBE = (QBE )(V) + FC

■ Basket Wonders (BW) wants to determine

both the quantity and sales break-even
points when:
■ Fixed costs are $100,000
■ Baskets are sold for $43.75 each
■ Variable costs are $18.75 per basket
 Break-Even Point (s)
Breakeven occurs when:
QBE = FC / (P - V)
QBE = $100,000 / ($43.75 - $18.75)
QBE = 4,000 Units
SBE = (QBE )(V) + FC
SBE = (4,000 )($18.75) + $100,000
SBE = $175,000
DOL (Degree of operating Leverage)

■ The extent of the presence of fixed operating costs

in a firm's income stream is measured by the degree
of operating leverage (DOL).
% Change in Earnings Before Int. and Taxes (EBIT)
Percentage Change in Sales
 DFL (Degree of financial Leverage)

■ The extent of the presence of fixed financial costs

in a firm's income stream is measured by the degree
of financial leverage (DFL).

Percentage Change in Net Income (NI)

%Change in Earnings Before Interest and Taxes (EBIT)
 DCL
■ 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).
Percentage Change in Net Income (NI)
Percentage Change in Sales
■ Notice that DCL = DFL × DOL
The Degree of Combined Leverage
(DCL)