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Leverage

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Leverage

Operating Leverage

Operating leverage results from the presence of fixed operating costs in a firm's income stream. The extent of the presence of fixed operating costs in a firm's income stream is measured by the degree of operating leverage (DOL).

DOL = Percentage Change in Earnings Before Interest and Taxes (EBIT)  
Percentage Change in Sales

Financial leverage results from the presence of fixed financial costs in a firm's income stream. The extent of the presence of fixed financial costs in a firm's income stream is measured by the degree of financial leverage (DFL).

DFL = Percentage Change in Net Income (NI)  
Percentage Change in Earnings Before Interest and Taxes (EBIT)

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).

DCL = Percentage Change in Net Income (NI)  
Percentage Change in Sales

Notice that DCL = DFL × DOL

Degree of Leverage

Firms that have greater degrees of leverage have greater levels of fixed costs. And as such, they tend to have greater break-even points than do firm's that do not have leverage. The advantage of having greater degrees of leverage is that as a firm's sales volume increases beyond the break-even point, its margins improve. The disadvantage of having greater degrees of leverage is that because the break-even point is higher, which means that the firm is required to achieve a higher sales volume in order to reach the break-even point. In good times when sales are high, a higher degree of leverage allows a firm to maximize profits. In bad times when sales are not as good, the firm is able to minimize its losses by having a lower degree of leverage.

Example:

In the example below, a firm's projected EBIT under two very different cost structures.

Income Statement High Leverage Low Leverage
Sales $ 100,000   100 % $ 100,000   100 %
Variable Operating Costs   -20,000   -20     -40,000   -40  
Contribution Margin   80,000   80     60,000   60  
Fixed Operating Costs   -40,000   -40     -20,000   -20  
EBIT $ 40,000   40 % $ 40,000   40 %

Notice the firm experiences the same level of sales, while it has very different cost structures.

Now notice what happens to the firm under each option when their sales decrease to $50,000.

Income Statement High Leverage Low Leverage
Sales $ 50,000   100 % $ 50,000   100 %
Variable Operating Costs   -10,000   -20     -20,000   -40  
Contribution Margin   40,000   80     30,000   60  
Fixed Operating Costs   -40,000   -80     -20,000   -40  
EBIT $ 0   0 % $ 10,000   20 %

When the sales drop to $50,000, the high leverage option declines to its break-even point while the low leverage option minimizes the loss. Now notice what happens to the firm's sales increase to $150,000.

Income Statement High Leverage Low Leverage
Sales $ 150,000   100 % $ 150,000   100 %
Variable Operating Costs   -30,000   -20     -60,000   -40  
Contribution Margin   120,000   80     90,000   60  
Fixed Operating Costs   -40,000   -27     -20,000   -13  
EBIT $ 80,000   53 % $ 70,000   47 %

When a firm's sales increase, the cost structure option with the higher degree of leverage is able to maximize the firm's profits.

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