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operating leverage

Page history last edited by Brian D Butler 11 years, 5 months ago

There are two important types of leverage to consider

 

1.  financial leverage - amount of debt that the firm must first pay back before there is any money left over for the  shareholders (debt vs. equity analysis)

2.  operating leverage - amount of fixed costs that the firm must cover in order to start making a profit (fixed costs vs. variable costs analysis). 

 

Both of these factors are related to the risk of a firm, and have the potential to magnify potential returns for good performance, and punish the firm for poor performance. 

 

 

Operating Leverage:

 

Compares the amount of fixed costs that the firm uses.   

 

When looking at a proposed project, it is useful to conduct a breakeven analysis to see how many units must be sold to cover your fixed costs.  This "job order costing" is done to figure out the amount of risk there is in the project.

 

 

 

 

 

 

The first thing you need to do is to make a Variable income statement, and figure out what is the contribution margin (revenues - variable costs).  You then subtract all of your fixed costs to come up with your operating income.  Subtract taxes to get your net income.  The goal is to make sure that you have enough contribution margin from this one project to cover your fixed costs of taking on this project (but please just consider only the relevant fixed costs for this project, and do not include non-relevant cash flows). 

 

The "indifference point" is where the project breaks even, ie where contribution margin just barely covers the fixed costs.

 

The risk of the project is determined by the operating leverage (contribution margin / net income).  the higher the operating leverage, the more risk of the project (or firm).  This is because if you take on additional debt (fixed interest costs), then the gap between C.M and N.I will be higher, which will result in a higher operating leverage ratio.  (net income will decrease with additional fixed expenses, but C.M stays high, so the ratio of CM / NI will be larger with added fixed costs).

 

This ratio is extremely useful when comparing two projects (or two companies).  The one with the higher operating leverage will show much higher returns at higher volumes of sales, but will suffer much larger losses at lower volume of sales.  We call it "leverage" because of the amplification effect.

 

 

 

 

 

 

 

Variable Income statement 

 

 

Revenues

-All Variable costs:

VMCGS (variable manufacturing COGS) *does not include FFO

VS&A (variable sales and admin costs)

____

C.M. (contribution margin)

-All Fixed costs

FFO (fixed factory overhead)

FS&A (fixed sales and admin)

___

Operating Income

- taxes

___

Net Income

 

 

 

This is different than the standard Gross Margin income statement that companies normally use when reporting (based on absorption costing). The Gross Profit income statement is different in that it combines all inventoriable costs into the COGS figure at the top (FFO is included in the COGS when the firm sells the products), and it also shows all S&A expenses as period costs at teh bottom of the Income statement, as shown here:

 

 

 

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