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CHAPTER 14

OPERATING
AND FINANCIAL
LEVERAGE
LEVERAGE – represents the use of fixed costs items
to magnify the firm’s results.

LEVERAGE IN BUSINESS
two primary decisions :
* You must determine the amount of fixed cost
plant and equipment you wish to use in then
production process.
* You must determine how will you finance the
business.
CVP ANALYSIS (COST-VOLUME-PROFIT)
- Is a powerful tool and vital in many business decisions
because it helps managers understand the relationships
among cost, volume and profit.
- focused on how the profits are affected by the following
elements:
a) selling prices
b) sales volume
c) unit variables costs
d) total fixed costs and
e) mix of products sold
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
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
CVP ANALYSIS FOR BREAKING PLANNING

Break-even point - is the level of sales volume where total revenues


and total expenses are equal , there is profit or loss.

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


Contribution Marginal per unit

2) Break-even point (peso) = Total Fixed Costs


Variable Costs
Sales
3)

a) Break-even sales for


multi-products firm = Total Fixed Cost
(Combined Units) Weighted Average 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


multi-products firm = Total Fixed Costs
( combined pesos) Weighted CM ratio

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


Total Weighted Sales (P)
• 1. Mr. Chua own a toy shop and want to figure out his
break-even point in units , His fixed costs per month is
P4,500, Variable costs is P 10 and his sales per toy is P
20.
Compute for the contribution margin and break-even
point in units.
SOLUTION ;

CM per unit = unit selling price - unit variable costs


= 20 - 10
= 10

Break-even point = Total fixed costs


( in units ) CM per unit
= 4,500
10
= 450
CVP ANALYSIS FOR REVENUE AND COST PLANNING
- used to determine the level of sales needed to achieve a
desired level of profit.
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 ( units) = Total fixed costs +Desired profit
Contribution Margin Ratio
ASSUMPTIONS
• Following are the assumptions of CVP ANALYSIS:
No. of units - Only driver for costs and revenues
- it assumes that the total variable costs and revenues would increase or
decrease only due to a change in no. of units.

Costs – Either Variable or fixed


- This assumption says that all the costs are either variable or fixed

No Change in price, variable costs , and fixed costs


- CVP analysis assumes that there are no changes in the price and variable
cost per unit irrespective of change in time period and relevant range
Sales Mix (Lopez, Angelica)
- refers to the relative proportions in which a company’s
products are sold.
- is to achieve the combination, or mix that will yield the
greatest amount of profits.
- changes in sales mix can cause perplexing variation’s in a
company profits.
CVP ANALYSIS FOR A MULTI-PRODUCTS FIRM
• 1. Lor, Inc. produces only two 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 P150,000. There are no other costs.
Required:
1. Compute the weighted contribution margin ratio
2. Compute the break-even point in sales pesos.
3. Compute the sales pesos necessary to generate a net income of P9,000
if total fixed costs will increase by 130%
SOLUTION:
A B
• 1. Sales mix ratio 60% 40%
Multiplied by : Contribution margin ratio 40% 15%
Weighted Contribution margin ratio 24% + 6% = 30%
• 2. Break-even Point (P) = Fixed costs
Weighted CMR
= P150,000
30%
= P500,000
• 3. Desired net income P 9.000
Add; Total Fixed Costs
( P150,000 X 130%) 195,000
Contribution Margin P 204,000
Divided by: Weighted CMR 30%
Sales necessary to generate
desired net income P680,000
• Operating Leverage
- is a measure of how sensitive net operating
income is to a given percentage change in peso sales.
- acts as a multiplier
Green Farm Yellow Farm

Present Expected Present Expected

Sales P
P100,000 P110,000 P100,000 110,000
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 P10,000 14,000 10,000 17,000
Degree of operating leverage

FORMULA ;

Degree of operating leverage = Contibution margin


Net operating Income
• The degree of operating leverage for two farms at P100,000 sales would be
computed as follows:
Green Farm P40,000 = 4 Yellow Farm P70,000 = 7
P10,000 P10,000

Percent Increase Degree of operating Percent Increase in net


in sales leverage Operating Income
(1) (2) (1) x (2)
Green Farm 10% 4 40%
Yellow Farm 10% 7 70%
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
• ILLUTRATIVE CASE 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 years is given below.

Total Per unit Percent of sales


Sales(20,000 units) P1,200,000 P60% 100%
Variable Expenses 90,000 45 ?
Contribution Margin 300,000 P15 ?
Fixed Expenses 240,000
Net Operating Income P 60,000
1 . Compute the company’s CM ratio and variable expense
ratio ?

CM ratio = Unit contribution margin Variable expense = Variable expense


Unit selling price ratio selling price
= 15 = 45
60 60
= 25 % = 75%
• Assume that the sales increase by P 400,000 next year. I f the cost behavior patterns
remain unchanged, by how much will the company’s net operating income increase?

Solution :

Increase in sales P400,000


Multiply by the CM ratio x25%
Expected increase in contribution margin P100,000
• Assume that next year management wants the company to earn a profit of at least
P90,000. How many units will have to be sold to meet this target profit?

Formula method :

Unit sales Target profit + P90,000 +


to attain = fixed expenses = P240,000 = 22,000 units
the target profit Contribution margin P15 per
per unit unit
• Compute the company’s margin of safety in both peso and percentage form.

Margin of safety in pesos = Total sales - Break even sales


= P1,200,000 - P960,000
= P240,000

Margin of safety percentage = Margin of safety in pesos = P240,000 = 20%


total sales P1,200,000
FINANCIAL LEVERAGE (JANINE FAJARDO)

• Reflects the amount of debt used in the capital structures of the firm.
• 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
ASSET LIABILITIES AND OWNER’S EQUITY
Operating Leverage Financial Leverage

IMPACT ON EARNINGS
we shall examine two financial plans for a firm, each
employing a significantly different amount of debt in the
capital structure. Financing totaling P200,000 is required to
carry the assets of the firm.
TOTAL ASSETS – P200,000
Plan A Plan B
(Leveraged) (Conservative)
Debt ( 8% P150,000 (P12,000 interest) P50,000(P4,000 interest)
interest)
Common (8,000 shares at (24,000 shares at
stock 50,000 P6.25) 150,000 P6.25)
Total Financing P 200,000 P200,000
DEGREE OF FINANCIAL LEVERAGE

• It measure the effect of a change in one variable to another variable.


• It may be also defined as the percentage change in earnings (EPS) that
occurs as a result of a percentage change in earnings before interest and
taxes (EBIT)

Degree of financial leverage = Percent Change in EPS


Percent change in EBIT
for purposes of computation, the formula for DFL may be conveniently
restated as:

Degree of financial leverage = Percent change in EPS


Percent change in EBIT

lets compute the degree of financial leverage for Plan A and Plan B at an EBIT
level of P 36,000. Plan A calls for P 12,000 of interest at all levels of financing,
and Plan B requires P4,000.
• Plan A ( Leveraged)
DFL = EBIT = P36,000 = P36,000 = 1.5
EBIT – 1 P36,000 – P12,000 P24,000

• Plan B (Conservative)
DFL = EBIT = P36,000 = P36,000 =1.1
EBIT – 1 P36,000 – P4,000 P32,000
LIMITATIONS TO USE OF FINANCIAL LEVERAGE
• We may quickly observe that if debt such a good thing, why sell any stock? With
exclusive debt financing at an EBIT level of P 36,000, we would have agree of
financial leverage factor (DFL) of 1.8.

DFL = EBIT = P36,000 = P36,000 = 1.8


EBIT – 1 P 36,000 – P16,000 P20,000

With no stock , we would borrow the full P200,000. (8% X P200,000 = P16,000
interest )
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.

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


Percent change in sales ( or volume )
Sales (P2 per unit x 80,000 units) P160,000 P200,000
less: fixed costs 60,000 60,000
variable costs (P 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 P12,000 P24,000
Shares 8,000 8,000
Earnings per share P 1.50 P 3.00

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