Chapter 4

Impact of Leverage

 Operating Leverage (OL)

 Financial Leverage (FL)
 Combined Leverage (CL)

Course: Management Accounting

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 What is Leverage?

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 2 more concepts that enhance our
understanding of risk...

1. Operating Leverage - affects a firm’s

business risk.

2. Financial Leverage - affects a firm’s

financial risk.

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 Business Risk
The variability or uncertainty of a firm’s
operating income (EBIT).

Stock
EBIT FIRM EPS holders

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 Business Risk
Affected by:
 Sales volume variability
 Competition
 Cost variability
 Product diversification
 Product demand
Operating Leverage

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 Operating Leverage
 The use of fixed operating costs as
opposed to variable operating costs.
 A firm with relatively high fixed
operating costs will experience more
variable operating profit if sales
change.

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 Operating Leverage

EBIT

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 Financial Risk
The variability or uncertainty of a firm’s
earnings per share (EPS) and the
increased probability of insolvency that
arises when a firm uses financial
leverage.

Stock
EBIT FIRM EPS holders

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 Financial Risk

The use of fixed-cost sources of financing

(debt, preferred stock) rather than
variable-cost sources (common stock).

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 Financial Risk

EPS

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 Break-even point/BEP
analysis

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 Costs

Suppose the firm has both fixed

operating costs (administrative salaries,
insurance, rent, property tax) and
variable operating costs (materials, labor,
energy, packaging, sales commissions).

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 Costs
Total sales

}
$
EBIT
+
Total cost

FC
{ -

BEP Q1 Quantity
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 Operating Leverage

What happens if the firm increases its

fixed operating costs and reduces (or
eliminates/removes) its variable costs?

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 Total sales

}
$
EBIT
+

{
Total cost
FC - = Fixed

BEP Q1 Quantity

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 With high operating leverage,
an increase in sales produces
a relatively larger increase in
operating income (EBIT)

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 Trade-off:
the firm has a higher breakeven point. If sales are not high
enough, the firm will not meet its fixed expenses!

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 Break-even calculations
Break-even point (in units)

FC
QB =
P - VC
QB = breakeven level of Q.
FC = total fixed costs.
P = price per unit.
VC = variable cost per unit.
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 Break-even calculations

Break-even point (in dollars)

FC
S* =
1 - VC
S
S* = breakeven level of sales.
FC = total fixed costs.
S = total sales.
VC = total variable costs.

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 Income Statement
Sales
(-) Variable costs
(-) Fixed costs
(=) Operating income/EBIT
(-) Interest
(=) EBT
(-) Tax
(=) Net Income
We call, contribution margin CM
CM = Sales – Variable costs
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 Income Statement
Sales
(-) Variable costs
(-) Fixed costs
(=) Operating income/EBIT
(-) Interest
(=) EBT
(-) Tax
(=) Net Income
EBT (1 - t) = Net Income
so Net Income/(1 - t) = EBT
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 Degree of Operating
Leverage (DOL)
Operating leverage : by using fixed
operating costs, a small change in sales
revenue is magnified into a larger change
in operating income.

This “multiplier effect” is called the

degree of operating leverage.

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 Degree of Operating Leverage
from Sales Level

DOL = % change in EBIT

% change in sales

Change in EBIT
= EBIT
Change in sales
Sales
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 Degree of Operating Leverage
from Sales Level
If we have the data, we can use this
formula:

Sales - Variable Costs

DOL =
EBIT

DOL = Q (P – V C )
Q (P – VC) – FC
Where,
Q: Quantity; P: Price; VC: Variable cost per unit; FC: Fixed cost

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 What does this tell us?

If DOL = 2, then a 1% increase in sales will

result in a 2% increase in operating income
(EBIT).

Stock
Sales EBIT EPS holders

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 Degree of Financial
Leverage (DFL)

Financial leverage: by using fixed cost

financing, a small change in operating
income is magnified into a larger change
in earnings per share.

This “multiplier effect” is called the

degree of financial leverage.

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 Degree of Financial
Leverage (DFL)

% change in EPS
DFL =
% change in EBIT

Change in EPS
= EPS
Change in EBIT
EBIT
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 Degree of Financial
Leverage (DFL)
If we have the data, we can use this formula:

EBIT
DFL =
EBIT – I

Where,
EBIT: Earnings Before Interest and Tax; I: Interest

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 What does this tell us?

If DFL = 3, then a 1% increase in

operating income will result in a 3%
increase in earnings per share/EPS.

Stock
Sales EBIT EPS holders

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 Degree of Combined
Leverage (DCL)
Combined leverage : by using
operating leverage and financial
leverage, a small change in sales is
magnified into a larger change in
earnings per share/EPS

This “multiplier effect” is called the

degree of combined leverage.

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 Degree of Combined
Leverage (DCL)

DCL = DOL x DFL

% change in EPS
=
% change in Sales

Change in EPS
= EPS
Change in Sales
Sales
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 Degree of Combined
Leverage (DCL)
If we have the data, we can use this
formula:

DCL = Sales - Variable Costs

EBIT – I

DCL = Q (P – V C )
Q (P – VC) – FC – I
Where,
Q: Quantity; P: Price; VC: Variable cost per unit; FC: Fixed cost;
I: Interest
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 What does this tell us?

If DCL = 4, then a 1% increase in sales

will result in a 4% increase in earnings
per share/EPS.

Stock
Sales EBIT EPS holders

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 Team Project:
Based on the following information on TIBI
Company, answer these questions:

1. If sales increase by 10%, what should

happen to operating income/EBIT?
2. If operating income increases by 10%, what
should happen to EPS?
3. If sales increase by 10%, what should be the
effect on EPS?

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 TIBI Company
Data:
Price $5
Variable cost per unit $3
Quantity (unit) 10,000
Sales (10,000 units) 50,000
Variable costs 30,000
Fixed costs 15,000
Interest paid 1,500
Tax rate 20%
Common shares outstanding 1,000,000
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 TIBI Company

Sales

DCL=5.7 DOL=4.0

EPS EBIT
DFL=1.4
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 TIBI Company
Income statement Base New Change
Quantity 10,000 11,000 10%
Sales 50,000 55,000
Variable Costs 30,000 33,000
Fixed Costs 15,000 15,000
EBIT 5,000 7,000 40%
Interest 1,500 1,500
EBT 3,500 5,500
Taxes 700 1,100
Net Income 2,800 4,400
EPS ($1,000) 2.8 4.4 57%

Reference: Horngren/ Introduction to Management Accounting

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