lOMoARcPSD|23031696

FINANCIAL MANAGEMENT

CHAPTER 8 - OPERATING AND FINANCIAL LEVERAGE

LEARNING OBJECTIVES

After studying Chapter 8, you should be able to:

1. Understand the concept and application of leverage in business.

2. Know how cost-volume-profit relationship is applied in determining a firm’s

a.) Breakeven volume

b.) Margins of safely
c.) Operating outcome if changes occur in various elements affecting profit such as
i. Selling price
ii. Volume
iii. Variable and fixed costs
iv. Sales mix

3. Understand the assumptions and limitations of the CVP analysis.

4. Explain the meaning of the operating leverage.

5. Calculate and interpret the firm’s degree of operating leverage.

6. Understand the nature of financial leverage.

7. Calculate and interpret the firm’s degree of financial leverage.

8. Explain the impact of combining operating leverage and financial leverage.

CHAPTER 14

OPERATING AND FINANCIAL LEVERAGE

INTRODUCTION

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

LEVERAGE IN A BUSINESS

Assume that there exists an opportunity to start your own business. You are to manufacture and market
industrial parts, such as ball bearings, wheels and casters. You are faced with two primary decisions.

First, you must determine the amount of fixed cost plant and equipment you wish to use in the production
process. By installing modern, sophisticated equipment, you can virtually eliminate labor in the
production of inventory. At high volume, you will do quite well, as most of your costs are fixed payments
for plant and equipment. If you decide to use expensive labor rather than machinery, you will lessen your
opportunity for profit, but at the same time, you will lower your exposure to risk (you can lay off part of
the workforce).
 lOMoARcPSD|23031696

Second, you must determine how you will finance the business. If you rely on debt financing and the
business is successful, you will generate substantial profits as an owner, paying only the fixed costs of
debt. Of course, if the business starts off poorly, the contractual obligations related to debt could mean
bankruptcy. As an alternative, you might decide to sell equity rather than borrow a step that will lower
your own profit potential but minimize your risk exposure.

In both decisions, you are making very explicit decisions about the use of leverage. To the extent that you
go with a heavy commitment to fixed costs in the operation of the firm, you are employing operating
leverage. To the extent that you utilize debt in the financing of the firm, you are engaging in financial
leverage. We shall carefully examine each type of leverage and then show the combined effect of both.

CVP ANALYSIS
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 (a) selling prices, (b) sales volume, (c) unit variable
costs, (d) total fixed costs, and (e) mix of products sold.

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?

Financial managers need to know the costs that are likely to be incurred under normal operating
conditions and how they might vary if conditions change. They need to understand which costs would
stay the same and which costs would follow the movement of volume and so on.

If the above items are known, the following relationships may be established:

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 and

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
 lOMoARcPSD|23031696

This CM ratio is very useful in that it shows how the contribution margin will be affected
by a given peso change in total sales. For instance, if a company’s CM ratio is 40%, it
means that for each peso increase in sales, total contribution margin will increase by
P0.40. Net income likewise will increase by P0.40 assuming that there are no changes in
fixed costs.

The CM ratio is particularly valuable in those situations where the manager must make
trade-offs between change in selling price and change in variable costs.

CVP ANALYSIS FOR BREAKING PLANNING

The starting point in many business plans is to determine the 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 or loss. This point can be determined by using CVP analysis. Break-even point can
be computed as follows:

1. Break-even point (units) = Total Fixed Costs

Contribution Margin per unit

2. Break-even point (pesos) = Total Fixed Costs

1- Variable Costs
Sales

3. a. Break-even sales for = Total Fixed Costs

multi- products firm Weighted Average
(combined units) 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 = Total Fixed Costs

multi-products firm Weighted CM ratio
(combined pesos)

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

Total Weighted Sales (P)
 lOMoARcPSD|23031696

CVP ANALYSIS FOR REVENUE AND COST PLANNING

CVP analysis can be used to determine the level of sales needed to achieve a desired level of profit. In
revenue planning, CVP analysis assists managers in determining the revenue required to achieve a desired
profit level. 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 (P) = Total Fixed Costs + Desired Profit

Contribution Margin Ratio

ASSUMPTIONS AND LIMITATIONS OF CVP ANALYSIS

CVP analysis constitutes a very important tool for management planning. Certain underlying assumptions
upon which it rests, however, place definite limitations on the conclusions which can be drawn from its
results. Whenever the underlying assumptions of CVP analysis do not correspond to a given situation, the
limitations, of the analysis must be clearly recognized if the break-even tool is to be useful and
educational.

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

Assumption/Limitation Comment

1. The analysis is valid for a 1. Failure to observe these limits

limited range of values - the would lead to working with
“relevant” - and a limited period unrealistic data.
of time.
2. All costs can be categorized as 2. Semi-variable costs present a
fixed or variable. problem that can be solved by
segregating fixed and variable
portion.
a. Variable costs change a. There is a danger that
proportionately with linear cost and revenue
volume within the relevant relationship may be used
volume range. when nonlinearities are
significant.
b. Fixed costs are constant b. Non-linear curves often
within the relevant volume have optimum quantities;
range. linear ones do not.
3. Revenues change 3. Price is constant for all volumes
 lOMoARcPSD|23031696

proportionately with volumes within the relevant range.

with selling price remaining
constant.
4. There is a constant product mix. 4. Data should be adjusted for any
shifts in product mix.
5. Changes in volume alone are 5. There are other factors affecting
responsible for changes in costs costs and revenues, but they are
and revenues. lessened if narrow time and
volume limits are applied.
6. There is no significant change in 6. Data should be adjusted if
inventories (i.e., in physical inventories change markedly.
units, sales volume equals
production volume.)
7. Operation leverage questions 7. This should be supported with
can be dealt with in the CVP capital budgeting approaches
framework. that consider the time value of
money.
8. The analysis is deterministic and 8. Uncertainly and a probabilities
appropriate data can be found. approach can be introduced.

SALES MIX

Sales mix refers to the relative proportion in which a company’s products are sold. The idea is to achieve
the combination, or mix that will yield the greatest 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 proportion of total sales.

Changes in the sales mix can cause perplexing variations in a company’s profits. A shift in the sales from
high-margin items to low-margin items can cause total profits to decrease even though total sales may
increase. Conversely, a shift in the sales mix from low-margin items to high-margin items can cause the
reverse effect; total profits may increase even though total sales decrease. It is one thing to achieve a
particular sales volume, it is quite another to sell the most profitable mix of products.

Illustrative Case 14-1. CVP Analysis for a Multi-Products Firm

Lor, Inc. produces only 2 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 ₱ 150,000. There are no other costs.

Required:

1. Compute the weighted contribution margin ratio.

2. Compute the break-even point in sales pesos.

 lOMoARcPSD|23031696

TOPIC 4 – FINANCIAL MANAGEMENT

3. Compute the sales pesos necessary to generate a net income of ₱ 9,000 if total fixed costs will

increase by 30%.

Solution: Lor, Inc.

1. A B
Sales mix ratio 60% 40%
Multiplied by: Contribution margin ratio 40% 15%
Weighted Contribution margin ratio 24% + 6% = 30%

2. BEP (₱)
= Fixed Costs
Weighted CMR
1= P150,000
30%

3. 1= ₱500,000
Desired net income ₱ 9,000
Add: Total Fixed Costs
(₱ 150,000 × 130%) 195,000
Contribution Margin ₱ 204,000
Divided by: Weighted CMR 30%
Sales necessary to generate
desired net income ₱ 680,000
OPERATING LEVERAGE

Operating leverage is a measure of how sensitive net operating income is to a given percentage change in
peso sales. Operating leverage acts as a multiplier. Id operating leverage is high, a small percentage
increase in sales can produce a much larger percentage increase in net operating income.

Operating leverage can be illustrated with use of the following data for two mango farms, Green farm and
Yellow Farm.

Green Farm Yellow Farm

Present Expected Present Expected

₱ ₱
Sales 100,000 110,000 ₱ 100,000 ₱ 110,000
Variable expenses 60,000 66,000 30,000 33,000
Contribution Margin 40,000 44,000 70,000 77,000
Fixed expenses 30,000 30,000 60,000 60,000
Net operating income ₱ 14,000 10,000 17,000
 lOMoARcPSD|23031696

10,000

DEGREE OF OPERATING LEVERAGE

The degree of operating leverage at a given level of sales is computed by the following formula:

Degree of operating leverage =Contribution margin

Net operating income
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. To illustrate, the degree of operating leverage for the two farms at ₱
100,000 sales would be computed as follows:

Green Farm ₱40,000 = 4

₱10,000

Yellow Farm ₱70,000 = 7

₱10,000

Because the degree of operating leverage for Green Farm is 4, the farm’s net operating income grows four
times as fast as its sales. In contrast, Yellow Farm’s net operating income grows seven times as fast as its
sales. Thus, if sales increase by 10%, then we can expect the net operating income of Green Farm to
increase by four times this amount, or by 40% and the net operating income of Yellow Farm to increase
by seven times this amount of by 70%.

Percent Increase Degree of Percent Increase

in Sales Operating in Net Operating
Leverage Income
(1) (2) (1) x (2)
Green Farm 10% 4 40%
Yellow Farm 10% 7 70%

What is responsible for the higher operating leverage at Yellow Farm? The only difference between the
two farms is their cost structure. If two companies have the same total revenue and same total expense but
different cost structures, then the company with the higher proportion of fixed costs in its costs structure
will have higher operating leverage.

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
LIMITATIONS OF ANALYSIS
 lOMoARcPSD|23031696

FINANCIAL MANAGEMENT

Throughout the analysis of operating leverage, it is assumed that a constant or linear function exists for
revenue and costs as volume changes. For example, ₱2 was used as the hypothetical sales price at all
levels of operation. In the “real world” however, the firm may face price weakness as an attempt to
capture an increasing market for the product is made or it may face cost overruns if there is movement
beyond an optimum-size operation. Relationships are not as fixed as have been assumed.

Illustrative Case 14-2. 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 year is
given below:

Total Per Unit Percent of

Sales
Sales (20,000 units) ₱ 1,200,000 ₱60 100%
Variable expenses 900,000 45 ?%
Contribution margin 300,000 ₱15 ?%
Fixed expenses 240,000
Net operating income ₱
60,000

Management is anxious to increase the company’s profit and has asked for an analysis of a number of
items.

Required:

1. Compute the company’s CM ratio and variable expense ratio.

2. Compute the company’s break-even point in both units and sales pesos. Use the equation method.
3. Assume that sales increase by ₱400,000 next year. If cost behavior patterns remain unchanged,
by how much will the company’s net operating income increase? Use the CM ratio to compute
the answer.
4. Refer to the original data. Assume that next year management wants the company to earn a profit
of at least ₱90,000. How many units will have to be sold to meet this target profit?
5. Refer to the original data. Compute the company’s margin of safety in both peso and percentage
form.
6. a. Compute the company’s degree of operating leverage at the present level of sales.
b. Assume that though a move intense effort by the sales staff, the company’s sales increase by
8% next year. By what percentage would you expect net operating income to increase? Use the
degree of operating leverage to obtain your answer.
c. Verify your answer to (b) by operating a new contribution format income statement showing
an 8% increase in sales.
7. In an effort to increase sales and profit, management is considering the use of a higher – quality
speaker. The higher-quality speaker would increase variable costs by ₱ 3 per unit, but
management could eliminate one quality inspector who is paid a salary of ₱30,000 per year. The
sales manager estimates that the higher – quality speaker would increase annual sales by at least
20%.
 lOMoARcPSD|23031696

FINANCIAL MANAGEMENT

a. Assuming that changes are made as described above, prepare a projected contribution format
income statement for next year. Show data on a total, per unit, and percentage basis.

b. Compute the company’s new break- even point in both units and pesos of sales. Use the
formula method.

c. Would you recommend that the charges be made?

Solution:

1.

CM ratio = Unit contribution margin = ₱15 = 25%

Unit selling price ₱60

2.
Variable = Variable expense = ₱45 = 75%
Expense ratio Selling price ₱60

3.

Income in sales ₱400,000

Multiply by the CM ratio x 25%
Expected increase in contribution ₱100,000

Because the fixed expenses are not expected to change, net operating income will increase by the entire
₱100,000 increase in contribution margin computed above.

4. Equation method:

Profit = Unit CM x Q – Fixed expenses

₱90,000 = (₱60 - ₱45) x Q - ₱240,000
₱15Q = ₱90,000 + ₱240,000
Q = ₱330,000 / ₱15
Q = 22,000 units

Formula method:

Unit Sales Target profit + ₱90,000 +

to attain = Fixed expenses = ₱240,000 = 22,000
the target Contribution ₱15 per units
profit margin per unit unit

5.
Margin of = Total sales – Break even sales
safety in pesos = ₱1,200,000 - ₱960,000 = ₱240,000
 lOMoARcPSD|23031696

FINANCIAL MANAGEMENT

Margin of Margin of
safety = safety in pesos = ₱ 240,000 = 20%
percentage Total sales ₱1,200,000

6.
a. Margin of Margin of safety in pesos ₱240,000
safety = Total sales = ₱1,200,000 = 20%
percentage

b. Expected increase in sales 8%

Degree of operating leverage x5
Expected increase in net operating income 40%

c. If sales increase by 8%, then 21,600 units (20,000 x 1.08 = 21,600) will be sold next year. The
new contribution format income statement would be as follows:

Total Per Unit Percent

Sales (21,600 units) ₱1,296,000 ₱60 100%
Variable expenses 975,000 45 75%
Contribution margin 324,000 ₱15 25%
Fixed expenses 240,000
Net operating income ₱ 84,000

Thus, the ₱84,000 expected net operating income for next year represents a 40% increase
over the ₱60,000 net operating income earned during the current year:

₱84,000 - ₱60,000 = ₱24,000 = 40% increase

₱60,000 ₱60,000

Note from net income statement above that the increase in sales from 20,000 to 21,600
units has increased both total sales and total variable expenses.

7. a. A 20% increase in sales would result in 24,000 being sold next year:

20,000 units x 1.20 = 24,000 units.

Total Per Unit Percent

of Sales
Sales (24,000 units) ₱1,440,000 ₱60 100%
Variable expenses 1,152,000 48 80%
Contribution margin 288,000 ₱12 20%
Fixed expenses 210,000
Net operating income ₱ 78,000

b.
Unit sales to breakeven = Fixed expenses
 lOMoARcPSD|23031696

Unit contribution margin

= ₱210,000 = 17,500 units
₱12 per unit

Peso sales to breakeven = Fixed expenses

CM ratio
= ₱210,000 = ₱1,050,000
0.20
c. Yes, based on these data the changes should be made. The changes increase the company’s net
operating income from the present ₱60,000 to ₱78,000 per year. Although the changes also result
in a higher break-even point (17,500 units as compared to the present 16,000 units), the
company’s margin of safety actually becomes greater than before:

Margin of safety = Total sales – Breakeven sales

in pesos
= ₱1,440,000 – ₱1,050,000 = ₱390,000

______________
*₱240,000 - ₱30,000 = ₱210,000
**₱45 + ₱3 = ₱48; ₱48 / ₱60 = 80%

FINANCIAL LEVERAGE
Having discussed the effect off 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 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 may have heard of the real estate developer who
borrows 100 percent of the costs of his project and will enjoy 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.

Statement of Financial Position

Assets Liabilities and Owner’s Equity

Operating Leverage Financial Leverage

Whereas operating leverage influences the mix of plant and equipment, financial 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.

IMPACT ON EARNINGS

In studying the impact of financial leverage, we shall examine two financial plans for a firm, each
employing a significantly different amount of debt in the capital structure. Financing totaling ₱200,000 is
required to carry the assets of the firm.

Downloaded by crisyl tapang (tapangcrisyl0517@gmil.com)

 lOMoARcPSD|23031696

Total Assets - ₱200,000

Plan A Plan B
(Leveraged) (Conservative)
Debt (8%
Interest) ₱150,000 (₱12,000 interest) ₱50,000 (₱4,000 interest)
Common (8,000 shares at (24,000 shares at
Stock 50,000 ₱6.25) 150,000 ₱6.25)
Total
financing ₱200,000 ₱200,000

Under leveraged Plan A, we will borrow ₱150,000 and sell 8,000 shares of stock at ₱6.25 to raise an
additional ₱50,000, whereas conservative Plan B calls for borrowing only ₱50,000 and acquiring an
additional ₱150,000 in stock with 24,000 shares.

In Figure 14-1 earnings per share are computed for the two plans at various levels of “earnings before
interest and taxes (EBIT)”. These earnings (EBIT) represent the operating income of the firm before
deductions are made for interest expense of taxes.

EBIT EBIT EBIT EBIT EBIT

₱0 ₱12,000 ₱16,000 ₱30,000 ₱50,000
Plan A Plan B Plan A Plan B Plan A Plan B Plan A Plan B Plan A Plan B
Levera- Conser- Levera- Conser- Levera- Conser- Levera- Conser- Levera- Conser-
ged vative ged vative ged vative ged vative ged vative
Earnings
before
interest
and taxes
(EBIT) ₱ 0 ₱ 0 ₱ 12,000 ₱ 12,000 ₱16,000 ₱16,000 ₱30,000 ₱30,000 ₱50,000 ₱50,000
Less:
Interest 12,000 4,000 12,000 4,000 12,000 4,000 12,000 4,000 12,000 4,000
Earnings
before
taxes
(EBT) (12,000) (4,000) 0 8,000 4,000 12,000 18,000 26,000 38,000 46,000
Less:
Taxes
(50%) (6,000) (2,000) 0 4,000 2,000 6,000 9,000 13,000 19,000 23,000
Earnings
after
taxes
(EAT) (6,000) (2,000) 0 ₱4,000 ₱2,000 ₱6,000 ₱9,000 ₱13,000 ₱19,000 ₱23,000
Shares 8,000 24,000 8,000 24,000 8,000 24,000 8,000 24,000 8,000 24,000
Earnings
Per share
(EPS) ₱(0.75) ₱ (0.08) ₱0 ₱0.17 ₱0.25 ₱0.25 ₱1.13 ₱0.54 ₱2.38 ₱0.96
Figure 14-1. Computation of earnings Per Share (EPS)
 lOMoARcPSD|23031696

It can be observed from the results shown in Figure 14-1 that although both plans assume the same
operating income, the impact of the two financing plans is very substantial. It is evident that the
conservative financial plan will produce better results at low income levels but the leveraged financial
plan will generate higher earnings per share as operating income or EBIT goes up. The firm would be
indifferent between the two plans at an EBIT level of ₱16,000.

DEGREE OF 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 percentage change in earnings before interest and taxes (EBIT).

Degree of Financial Leverage = Percentage change in EPS

Percentage change in EBIT

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

Degree of Financial Leverage = EBIT

EBIT – 1

Let’s compute the degree of financial leverage for Plan A and Plan B at an EBIT level of ₱36,000. Plan A
cost for ₱12,000 at interest of all levels of financing and Plan B requires ₱4,000.

PLAN A (Leveraged)

DFL = EBIT = ₱36,000 = ₱36,000 = 1.5

EBIT – 1 ₱36,000 – ₱12,000 ₱24,000

PLAN B (Conservative)

DFL = EBIT = ₱36,000 = ₱36,000 = 1.1

EBIT – 1 ₱36,000 - ₱4,000 ₱32,000

As expected, Plan A has a much higher degree of financial leverage. At an EBIT level of ₱36,000, a 1
percent increase in earnings will produce a 1.5 percent increase in earnings per share under Plan A, but
only 1.1 percent increase under Plan B. DFL may be computed for any level of operation, and it will
change from point to point, but Plan A will always exceed Plan B.

LIMITATIONS TO USE FINANCIAL LEVERAGE

We may quickly observe that if debt is such a good thing, why sell any stock? With exclusive debt
financing at an EBIT level of ₱36,000, we would have agree if financial leverage factor (DFL) of 1.8.

DFL = EBIT = ₱36,000 = ₱36,000 = 1.8

EBIT – 1 ₱36,000 - ₱16,000 ₱20,000

With no stock, we would borrow the full ₱200,000. (8% × ₱200,000 = ₱16,000 interest).

As stressed out throughout the text, debt financing and financial leverage offer unique advantages, but
only up to a point at debt may be detrimental to the firm. For example, as we expand the use of debt in
our capital structure, lenders will perceive a greater financial risk for the firm. For the reason, they may
 lOMoARcPSD|23031696

FINANCIAL MANAGEMENT

raise the average interest rate to be paid and may demand that certain restrictions be placed on the
corporation. Furthermore, concerned common stockholders may drive down the price of the stock forcing
us away from the objective of maximizing the firm’s overall value in the market. The impact of financial
leverage must be carefully weighed by firm’s with high debt.

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.

Figure 14-2 shows what happens to profitability as the firm’s sales go from ₱160,000 (80,000 units) to
₱200,000 (100,000 units).

Sales (₱2 per unit × 80,000 units) ₱160,000 ₱200,000

Less: Fixed Costs 60,000 60,000
Variable Costs (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 12,000 24,000
Shares / 8,000 / 8,000
Earnings per share ₱ 1.50 ₱ 3.00
Figure 14-2 Combining Operating and Financial Leverage

The Formula for degree of combined leverage is stated as:

Degree of combined leverage (DCL) = Percentage change in EPS

Percentage change in Sales (or volume)

Using the data from Figure 14-2, the degree of combined leverage is:

₱1.50
Percentage change in EPS = ₱1.50 x 100 = 100% = 4
Percentage change in Sales (or Volume) ₱40,000 25%
₱160,000 x 100

Every percentage in point change in sales will be reflected in a 4 percent change in earnings per share at
this level of operation.

The formula is:

Degree of Combined Leverage (DCL) = Q(P-VC)

Q(P-VC) – FC – I
From Figure 14-2, Q (quantity) = 80,000; P (price per unit) = 2.00; VC (variable cost per unit) = ₱0.80;
FC (fixed cost) = ₱60,000; and I (interest) = ₱12,000.

DCL = 80,000 (₱2.00 - ₱0.80)

80,000 (₱2.00 - ₱0.80) – ₱60,000 – 12,000
 lOMoARcPSD|23031696

FINANCIAL MANAGEMENT

= 80,000 (₱1.20)
80,000 (₱1.20) – ₱72,000
= ₱96,000
₱96,000 – ₱72,000
DCL = ₱96,000 = 4
₱24,000.00