Module 7 – Leverage

Learning Objectives

At the end of the module, the student should be able to

 Understand the concepts of financial leverage, operating leverage and total

leverage
 Explain the basic of break-even analysis and operating leverage and how
they relate each other
 Determine how to measure operating leverage and financial leverage and
distinguish between them
 Analyze the relationship between EBIT and EPS
 Discuss the importance of leverages
 Illustrate various practical problems of leverage

INTRODUCTION
In the arena of financing decisions, the capital structure decision assumes
greater significance. As it deals with debt equity composition of the
organization, the resultant risk and return for shareholders is of utmost
concern for finance managers. If the borrowed funds are more than
owners’ funds, it results in increase in shareholders’ earnings. At the same
time, it also increases the risk of the organization. In a situation where the
proportion of the equity funds is more than the proportion of the borrowed
funds, the return as well as risk of the shareholders will be very low. This
underlines the importance of having an optimal capital structure where risk
and return to shareholders be matched. The effect of capital structure
where risk and return to shareholders may judiciously help the finance
managers to decide their short term and long term strategies. The behavior
and application of leverage helps in examining the whole issue in right
perspective.
 CONCEPT AND TYPES OF LEVERAGES

The dictionary meaning of the term leverage refers to: “an increased means for
accomplishing some purpose”. It helps us in lifting heavy objects by the
magnification of force when a lever is applied to a function.

James Horne has defined leverage is that portion of a business enterprise’s fixed
cost that represent a risk to the firm.

Generally, increases in leverage result in increased return and risk, whereas

decreases in leverage result in decreased return and risk. The amount of leverage
in the firm’s capital structure—the mix of long-term debt and equity maintained
by the firm—can significantly affect its value by affecting return and risk. Unlike
some causes of risk, management has almost complete control over the risk
introduced through the use of leverage. Because of its effect on value, the
financial manager must understand how to measure and evaluate leverage,
particularly when making capital structure decisions.

Types of Leverage

The three basic types of leverage can best be defined as:

a) Operating Leverage
b) Financial Leverage
c) Total Leverage

 Operating leverage – A measure of operating risk, refers to the fixed

operating costs found in the income statement. It is concerned with the
relationship between the firm’s revenue and its earnings before interest and
taxes (EBIT). In short, basically Operating leverage is concerned with the
relationship between the firm’s sales revenue and its earnings before
interest and taxes, or EBIT. (EBIT is a descriptive label for operating profits.)

 Financial leverage – a measure of financial risk, refers to a long-term

financing with fixed financing charges of the business enterprise’s assets. It
 is concerned with the relationship between the firm’s EBIT and its common
stock earnings per share (EPS). Likewise, it refers to usage of debt in capital
structure. It is the use of fixed cost capital (debt) in the total capitalization of
the firm. Fixed cost capital includes loans, debentures and preferences share
capital.

 Total leverage is concerned with the relationship between the firm’s sales
revenue and EPS.

With reference to the firm’s income statement, as shown in the general

income statement format in Table 7.1.

Table 7.1 General Income Statement Format and Types of Leverage

Sales revenue …………………….…………………..… Pxxxx
Less: Cost of goods sold ………….................... xxxx
Operating Leverage Gross margin/profit ……………….…………………. Pxxxx
Less: Operating expenses …………………………... xxxx
Earnings before Interest & Tax (EBIT)…………..Pxxxx Total
Less: Interest ………………………………………..…….. xxxx Leverage

Net profit before taxes …………..…………..……….Pxxxx

Financial Leverage Less: Taxes ……………………………………………..…… xxxx
Net profit after taxes …………………….………….… Pxxxx
Less: Preferred stock dividends ………………..…. xxxx
Earnings available for common shareholders. Pxxxx

Earning per share ………………………………………..P xxx

Operating Leverages Versus Financial Leverage

Operating Leverage Financial Leverage
Operating leverage is concerned with investment Financial leverage is concerned with financing
activities of the firm. activities of the firm.
It is determined by the cost structure of the firm. It is determined by the capital structure of the firm.
It is the firm’s ability to use fixed operating costs It is the firm’s ability to use fixed financial charges
to magnify the effects of changes in sales on its to magnify the effects of changes in EBIT on its
earnings before interest and taxes earnings per share.
 Operating Leverage
The higher the proportion of fixed operating
costs to the total operating costs in the cost
structure of a firm, the higher is the degree of
operating leverage.
Degree of operating leverage enables us to
measure the business risk associated with the
firm.
Financial Leverage
The higher the proportion of fixed charges bearing
capital to total financial changes in the capital
structure of a firm, the higher is the degrees of
financial leverage.
Degree of financial leverage enables us to measure
the degree of financial risk, associated with the
firm.

Break-even Analysis, Operating Leverage and Financial Leverage

Break-even analysis, which is closely related to operating leverage,
determines break-even sales – the financial crossover point which revenues
exactly match costs. Although this analysis does not show up in corporate
earnings reports, financial officers find it an extremely useful measurement.

Break-even analysis, sometimes called cost-volume-profit analysis, is used by

the firm (1) to determine the level of operations necessary to cover all operating
costs and (2) to evaluate the profitability associated with various levels of sales.
The firm’s operating breakeven point is the level of sales necessary to cover all
operating costs. Basically, break-even analysis determines the break-even point
(BEP) – the point at which sales revenue equal production cost and expenses.
The break-even point can also be defined in terms of physical units produced, or
of the level of capacity utilization at which sales revenues and production costs
and expenses match each other. At that point, earnings before interest and
taxes equals zero.

The first step in finding the operating break-even point is to divide the cost
of goods sold and operating expenses into fixed and variable operating costs.
Fixed costs are a function of time, not sales volume, and are typically
contractual; rent, for example, is a fixed cost. Variable costs vary directly with
sales and are a function of volume, not time; shipping costs, for example, are a
variable cost.
 Using the following variables, we can recast the operating portion of the
firm’s income statement given in Table 7.1 into the algebraic representation
shown in Table 7.2.
P = sale price per unit
Q = sales quantity in units
FC = fixed operating cost per period
VC = variable operating cost per unit

Rewriting the algebraic calculations in Table 7.2 as a formula for earnings

before interest and taxes yields

Equation:
EBIT = (P x Q) – FC – (VC x Q)

Simplifying Equation yields

EBIT = Q x (P – VC) – FC

Table 7.2 Operating Leverage, Costs and Break-even Analysis

Algebraic
Item representation
Sales revenue …………………….…………….. Pxxxx (PxQ)
Less: Fixed operating cost…………............(xxxx) FC
Operating Leverage Variable operating cost……………....(xxxx) ( VC x Q )
Earnings before Interest & Taxes………...Pxxxx EBIT .

As noted above, the operating breakeven point is the level of sales at

which all fixed and variable operating costs are covered—the level at which
EBIT equals P0. Setting EBIT equal to zero and solving Equation 7.2 for Q
yield
Q = FC/P – VC
Q is the firm’s operating breakeven point in unit.
Break-even point can be computed as follows:

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

Contribution Margin per unit

2) Break-even point in (peso) = Total Fixed Cost .

1 – Variable Costs/Sales
OR (alternative formula)

Break-even point in (peso) = Break-even point (units) x Selling price per unit

Note the following important concepts:

 Contribution margin (CM) – the excess of sales (S) over the variable
costs (VC) of the product. It is the amount of money available to
cover fixed costs (FC) and to generate profits. Symbolically,
CM = S – VC.

 Unit CM – the excess of the unit selling price ( p ) over the unit
variable cost ( vc ). Symbolically, unit CM = p – v.

To illustrate these concepts, consider the following data:

Total Per Unit Percent
Sales (1,500 units) …………P37,500 …….. P25 ………….. 100%
Less: Variable cost ………… 15,000 …….. 10 …………… 40%
Contribution margin ………P22,500 ……. P 15 ………….. 60%
Less: Fixed Cost …………….. 15,000
Net income ……………………P 7,500

From the date listed above,

a) Contribution margin (CM) = S – VC

= P37,500 – P15,000
= P22,500

b) Unit CM = p – v = P25 – P10 = P15

 c) Break-even point (units) = Total Fixed Cost .
Contribution Margin per unit

= P15,000/P15

= 1,000 units

d) Break-even point in (peso) = Total Fixed Cost .

1 – Variable Costs/Sales

= P15,000 .

1 – P15,000/P37,500

= P15,000/ 1 – 0.40

= P 25,000
OR

Break-even point in (peso) = Break-even point (units) x Selling price per unit
= 1,000 units x P25
= P25,000

Target Sales Volume to earn a Desired Amount of Profit

This is the amount of sales needed to earn a desired amount of profit. The
equation or formula that may be use in computing the following:

Sales (units) = Total Fixed Cost + Desired Profit .

Contribution Margin per unit

OR

Sales 9pesos) = Total Fixed Cost + Desired Profit .

Contribution Margin ratio *

*Contribution Margin Ratio = = Contribution Margin in Peso .

Actual or Budgeted Sales in peso
 To illustrate these concepts, consider the following data:

Basic Illustration Corporation produces and sell a single product. The

selling price is P25 and the variable costs is P15 per unit. .The corporation
fixed cost is P100,000 per month. Average monthly sales is 11,000 units.

Required: Compute the following, if –

a) The corporation desires to earn profit of P20,000 before
tax, determines the total sales the corporation have to
generate?
b) The company would like to earn a profit of 6% of such sales,
determine how much sales in peso must the corporation
has to generate?
c) The company would like to earn profit of P2 per unit, how
many units the company have to sell to earn P2 per unit?

SOLUTION:
a) Required sales to earn desired profit before tax

Sales in units = Fixed Cost + Desired Profit .

Contribution Margin per unit

= P100,000 + P 20,000 .
P 10

= 12,000 . units

Sales in pesos = Fixed Cost + Desired Profit .

Contribution Margin ratio

= P100,000 + P 20,000 .
40%

= P300,000 .
 b) Required sales to earn desired profit before tax

Sales in peso = Total Fixed Cost in pesos .

CM ratio – Profit ratio

= P100,000 .
40% – 6%

= P294,118 .

c) Required sales in units to earn a desired profit per unit

Sales in units = Total Fixed Cost in pesos .

CM per unit – Profit per unit

= P100,000 .
P10 – P2

= 12,500 . units

Operating Leverage
Operating leverage, a measure of operating risk, arises from the business
enterprise’s use of fixed operating cost. A simple indication of operating
leverage is the impact of a change in sales on earnings before interest and
taxes (EBIT). The formula is:

Operating Leverage = Total Contribution Margin in pesos .

Total CM in pesos – Total fixed Cost (EBIT)

To illustrate:
The EFG Business Enterprise manufactures and sells doors to home
builders. The doors are sold for P2,500 each. Variable cost are P1,500 per
 door, and fixed operating costs total P5,000,000. Assume further that the
EFG Business Enterprises is currently selling 6,000 doors per year. Its degree
of operating leverage is:

Operating Leverage = Total Contribution Margin in pesos

Total CM in pesos – Total fixed Cost

= (P2,500 – P1,500) x 6,000 doors .

[(P2,500 – P1,500) x 6,000] – P5,000,000

= P6,000,000/P6,000,000 – P5,000,000
= P6,000,000/P1,000,000
= 6 .

To illustrate further, EFG Business Enterprise’s sales would increase by 10%,

its profit before tax would increase by 60%.

% change in Profit = % change in sales x Operating Leverage factor

= 10% x 6
= 60%

Proof: Present Proposed % Change

Sales ………………….……P15,000,000 P16,500,000 * 10%
Variable cost …………… 9,000,000 9,900,000 **
Contribution margin…P 6,000,000 P 6,600,000
Fixed cost ……………….. 5,000,000 5,000,000
Profit (EBIT) …………….P 1,000,000 P 1,600,000 60% ***

*P15,000,000 x 10%
**P9,000,000 x
*** (P1,600,000 – P1,000,000)/P1,600,000

Because the result is greater than 1, operating leverage exists. The

degree of operating leverage of six (6), which means if sales increase by 10
 percent, the business enterprise can expect its net income to increase by
six (6) times that amount, or 60 percent. It is important to note that all
types of leverage are two-edged swords. When sales decrease by some
percentage, the impact on EBIT of that decrease will be an even larger
percentage decline.

NOTES TO REMEMBER:
1. Sales increases by only 10%, but profit (EBIT) increased 6 times the
increase in sales, or by 60%
2. The increase of 10% in sales is due to change in units (quantity).
3. Since units change by 10%, both the total variable cost and contribution
margin increased by the same percentage (10%).
4. Selling price per unit, variable cost per unit, and total fixed costs are
assumed to be constant.
5. If there is no change in selling price and variable cost per unit,
Contribution Margin per unit, Contribution Margin Ratio, and Variable
Cost Ratio will all remain the same.
6. If contribution margin is more than fixed cost, it is favorable operating
leverage. In case of vice-versa, it is unfavorable financial leverage.
7. Leverage is achieved by increasing fixed cost while lowering variable cost.

Another illustration:
The following data were available for your analysis:
Selling price per unit ………………………..P 20
Variable cost per unit ………………………. 12
Actual sales …………………………………..200 units
Installed capacity ………………………….300 units

Required: Compute the degree of operating leverage in each of the following

two situations.
(a) when fixed costs are P1,000
(b) when fixed costs are P800
Solution:

Items Fixed costs @ P1,000 Fixed costs @ P800

Sales (P20 x 200 units) …………………………. P 4,000 P 4,000
Less: Variable cost (P12 x 200 units)…….. 2,400 2,400
Contribution margin ……………………………. P 1,600 P 1,600
Less: Fixed costs ………………………………….. 1,000 800
Earning before Interest and Tax (EBIT)…. P 600 P 800

Operating Leverage (CM/EBIT) ……………. P1,600/P600 = 2.67 P1,600/P800 = 2.0

Financial Leverage
Financial leverage is a measure of financial risk that arises from the
presence of debt and/or preference share capital in the business enterprise’s
capital structure. One way to measure financial leverage is to determine how
earning per share (EPS) are affected by a change in EBIT. When financial
leverage is used, changes in EBIT translate into larger changes in EPS. If EBIT
falls, a financially leveraged business enterprise will experience negative
changes in EPS that are larger than the relative decline in EBIT. Again,
leverage is a two-edged sword.
Generally, financial leverage as the potential use of fixed financial costs
to magnify the effects of changes in earnings before interest and taxes on the
firm’s earnings per share. The two fixed financial costs that may be found on
the firm’s income statement are (1) interest on debt and (2) preferred stock
dividends. These charges must be paid regardless of the amount of EBIT
available to pay them.

Basically, financial leverage affects earnings after interest and taxes. The
degree of financial leverage is the percentage change in earnings available to
ordinary shareholders and can be computed as follows:

Degree of Financial Leverage (DFL) = EBIT .

EBIT - Interest
 To illustrate:
The EFG Business Enterprise manufactures and sells doors to home
builders. The doors are sold for P2,500 each. Variable cost are P1,500 per
door, and fixed operating costs total P5,000,000. Assume further that the
EFG Business Enterprises is currently selling 6,000 doors per year and has a
total financial charges of P2,430. Its degree of financial leverage is:

(DFL) = EBIT .
EBIT – Interest
= ( 6,000 x P2,500) – (6,000 x P1,500) – P5,000,000 .
[( 6,000 x P2,500) – (6,000 x P1,500) – P5,000,000] – P2,430

= P10,000 .
P10,000 – P2,430

= 1.32

Illustration.
ABC Ltd. has the following capital structure :

Equity share capital (of P100 each) ……………………………………..P100,000

10% Preference share capital (of P100 each)…………………….…. 200,000
10% debentures (of P100 each)……………………………………………. 200,000

If EBIT is (a) P100,000 (b) P80,000 and (c) P120,000, calculate financial
leverage under three situations. Assume 50% tax rate.

Solution:
Items A B C
Earning before interest and taxes (EBIT) ……………….. P100,000 P 80,000 P120,000
Less: Interest on Debentures (P200,000 x 10%) …….. 20,000 20,000 20,000
Earning before Taxes (EBT) ……………………………………. P 80,000 P 60,000 P100,000
Less: Income tax (EBT x 50%) ………………………………… 40,000 30,000 50,000
Earning after tax (EAT) ………………………………………….. P 40,000 P 30,000 P 50,000
Less: Preference dividend (P200,000 x 10%) …………. 20,000 20,000 20,000
Earnings for Equity shareholders (EES)…………………… P 20,000 P 10,000 P 30,000
Number of shares …………………………………………………. 10,000 10,000 10,000
Earning per share (EPS) EES/No. of shares …………….. P2 P1 P3

Financial Leverage (EBIT/EBT) ……………………………… P100,000 P80,000 P120,000

P80,000 P60,000 P100,000
1.25 1.33 1.2

Total Leverage
We also can assess the combined effect of operating and financial
leverage on the firm’s risk by using a framework similar to that used to develop
the individual concepts of leverage. This combined effect, or total leverage, can
be defined as the potential use of fixed costs, both operating and financial, to
magnify the effect of changes in sales on the firm’s earnings per share. Total
leverage can therefore be viewed as the total impact of the fixed costs in the
firm’s operating and financial structure.
This interrelationship can be quantified by computing for the degree of
total leverage (DTL) as follows:

Degree of Total Leverage (DTL) = (DOL) x (DFL)

Mental Calisthenics 7-1

The following are sales and cost data of two companies in the transportation
industry.
Company A . Company B .
Amount . % of sales Amount % of sales
Sales ………………………. P100,000 100% P100,000 100%
Variable costs ………… 60,000 60% 30,000 30%
Contribution margin .. P 40,000 40% P 70,000 70%
Fixed costs ………………. 30,000 60,000
Net income ……………… P 10,000 P 10,000
Required: 1) Calculate the operating leverage of each company. If sales increase,
which company benefits more? How do you know?
2) Assume sales rise 10% in the next year. Calculate the percentage
increase in profit for each company. Are the results what you
expected?

Mental Calisthenics 7-2

The GSU Company manufactures skates. The company’s income statement
for 2021 is as follows:

GSU Company
Income Statement
For the Year Ended December 31, 2021

Sales (10,000 skates @ P50 each) …………………………………………….P500,000

Less: Variable cost (10,000 skates @ P20) ……………….P200,000
Fixed costs ……………………………………………………… 150,000 350,000
Earnings before interest and taxes (EBIT) …………………………………P150,000
Less: Interest expense ……………………………………………………………… 60,000
Earnings before taxes (EBT) ………………………………………………………P 90,000
Less: Income tax expense (40%) ……………………………………………….. 36,000
Earnings after taxes (EAT) ………………………………………………………..P 54,000

Given this income statement, compute the following:

a) Degree of operating leverage.
b) Degree pf financial leverage.
c) Degree of total leverage.
d) Break-even point in units (number of skates).

Capital Structure
Capital structure is the combination of capitals from different sources of
finance. The capital of a company consists of equity share holders’ fund,
preference share capital and long term external debts. The source and quantum
of capital is decided keeping in mind following factors:
  Control – capital structure should be designed in such a manner that
existing shareholders continue to hold majority share.
 Risk – capital structure should be designed to such a manner that financial
risk of the company does not increases beyond tolerable limit.
 Cost – overall cost of capital remains minimum.

Practically it is difficult to achieve all of the above three goals together hence
a finance manager has to make a balance among these three objectives.
However, the objective of a company is to maximize the value of the company
and it is prime objective while deciding the optimal capital structure. Capital
structure decision refers to deciding the forms of financing (which sources to be
tapped); their actual requirements (amount to be funded) and their relative
proportions (mix) in total capitalization.

Thus, capital structure is one of the most complex areas of financial decision
making because of its interrelationship with other financial decision variables.
Poor capital structure decisions can result in a high cost of capital, thereby
lowering the NPVs of projects and making more of them unacceptable. Effective
capital structure decisions can lower the cost of capital, resulting in higher NPVs
and more acceptable projects—and thereby increasing the value of the firm.

Checks your answer

MC 7-1
Requirement 1

Operating leverage = Contribution margin/EBIT

Company A’s operating leverage = P40,000/P10,000 = 4 .
Company B’s operating leverage = P70,000/P10,000 = 7 .

If sales increase, company B will benefit more. Company B has a higher

proportion of fixed costs in relation to variable costs, therefore it has a higher
operating leverage than does Company A. The degree of operating leverage is a
measure, at a specific level of sales of how a percentage change in sales volume
will affect profits. The higher the operating leverage, the more sensitive profits
are to changes in sales volume.

Requirement 2:
Company A . Company B .
Amount . % of sales Amount % of sales
Sales ………………………. P110,000 100% P110,000 100%
Variable costs ………… 66,000 60% 33,000 30%
Contribution margin .. P 44,000 40% P 77,000 70%
Fixed costs ………………. 30,000 60,000
Net income ……………… P 14,000 P 17,000

Company A’s change in profits = P14,000 – P10,000

P 10,000
= 40%

Company B’s change in profits = P17,000 – P10,000

P 10,000
= 70%

Yes, these results are what we expected. Operating leverage indicates

what change in net income can be expected from a change in sales volume. An
operating leverage of 4 times that the change in net income will be 4 times as
large as the change in sales volume. Therefore, if sales increased by 10%, net
income should increase by 40%. This is precisely what happened. The same
logic applies to Company B.

MC 7-2

a) DOL = Total Contribution Margin in pesos

Total CM in pesos – Total fixed Cost

= (P30 x 10,000 skates) .

(P30 x 10,000 skates) – P150,000
 = P300,000 .
P300,000 – P150,000

= 2 .

b) DFL = EBIT .
EBIT - Interest

= P150,000 .
P150,000 – P60,000

= 1.67 .

c) DTL = (DOL) x (DFL)

= 2 x 1.67
= 3.34 .

d) Break-even point (units) = Total Fixed Cost .

Contribution Margin per unit

= P150,000 .
( P50 – P20)

= 5,000 skates .

Seatwork Exercises

Whole Foods Market has been approached by a robotics company with

a proposal to significantly automate one of its stores. All stocking of shelves
and bagging of groceries would be done by robots. Customers would check
out through self-service scanners and point-of-sale terminals. Any assistance
would be provided by robots. Management has compiled the following
comparative data for one average-sized store.
 Old New .
Sales …………………………….P3,600,000 P 3,600,000
Variable cost ………. ……… 2,800,000 2,000,000
Contribution margin …….P 800,000 P 1,600,000
Fixed costs …………………. 480,000 1,280,000
Net Income ………………… P 320,000 P 320,000

INSTRUCTIONS: Use the information provided above to do the following-

a) Compute the degree of operating leverage for the

company under each scenario, and discuss your results.
b) Compute the break-even point in pesos for the company
under each scenario, and discuss your results.

Activity 7 (Self Test Exercise)

A. Multiple choice - Theory

1) Defined as that portion of a business enterprise’s fixed costs that

represent a risk to the firm:
a) leverage c) financial risk
b) asset d) none of the above

2) A measure of operating risk that refers to the fixed operating costs

found in the income statement:
a) operating leverage c) break-even analysis
b) financial leverage d) total leverage

3) A measure of financial risk that refers to a long-term financing with fixed

financing charges, of the business enterprise’s assets:
a) operating leverage c) break-even analysis
b) financial leverage d) total leverage

4) Determine the financial crossover point at which revenues exactly

match costs:
a) operating leverage c) break-even analysis
b) financial leverage d) total leverage
5) The excess of sales over the variable costs of the product
a) contribution margin c) fixed contribution margin
b) unit contribution margin d) all of the above

6) The amount of money available to cover fixed costs (FC) and to generate
profits:
a) contribution margin c) fixed contribution margin
b) unit contribution margin d) none of the above

7) The concept of operating leverage involves the use of returns at high

levels of operation
a) fixed costs c) marginal costs
b) variable costs d) semi-variable costs

8) Which of the following is concerned with the change in operating profit

as a result of a change in volume?
a) financial leverage c) operating leverage
b) break-even point d) total leverage

9) The degree of operating leverage is computed as

a) Percent change in operating profit divided by percent change in
net income
b) Percent change in volume divided by percent change in
operating profit
c) Percent change in EPS divided by percent change in operating
income
d) Percent change in operating income divided by percent change
in volume

10) Financial leverage is concerned with the relation between

a) Changes in volume and changes in EPS
b) Changes in volume and changes in EBIT
c) Changes in EBIT and changes in EPS
d) Changes in EBIT and changes in operating income
B. Multiple choice – Practical Problem

Use the following information to answer questions 1 to 5 –

Sales (30,000 units) ………………………….P 150,000

Variable costs …………………………………… 100,800
Contribution margin …………………………P 49,200
Fixed manufacturing costs ……………….. 24,000
Operating income …………………………….P 25,200
Interest ……………………………………………. 18,000
Earnings before taxes ……………………….P 7,200
Taxes (at 30%) ………………………………….. 2,160
Net income ……………………………………….P 5,040

Shares outstanding ……………………………. 600

1) This firm’s break-even point is

a) 4,800 units c) 7,142 units
b) 14,634 units d) 18,000 units

2) The Degree of Operating Leverage (DOL) is

a) 1.58 c) 3.50
b) 1.95 d) 1.40

3) The Degree of Financial Leverage (DFL) is

a) 3.50 c) 1.95
b) 1.40 d) 1.58

4) The Degree of Total Leverage (DTL) is

a) 3.08 c) 2.73
b) 5.45 d) 6.83

5) At a sales level of P90,000, Blue Company’s contribution margin is

P24,000. If the degree of operating leverage is 6 at a P90,000 sales
level, net income must equal
a) P15,000 c) P4,000
b) P11,000 d) P20,000
 CASE PROBLEM
The CVP income statements shown below are available for Mika
Company and Allie Company.

Mika Company Allie Company

Sales revenue……………….P 600,000 P 600,000
Variable cost ……………….. 320,000 120,000
Contribution margin …..P 280,000 P 480,000
Fixed costs ………………….. 189,000 380,000
Net Income …………………P 100,000 P 100,000

INSTRUCTIONS: Use the information provided above to do the following-

c) Compute the degree of operating leverage for each

company and interpret your results.
d) Assuming that sales revenue increases by 10%, prepare a
variable costing income statement for each company.
e) Discuss how the cost structure of these two companies
affects their operating leverage and profitability.

End of Module 7