Leverage operational and financial. Level, effect, estimation, ratio, formula operating leverage

In the economic literature it is quite often that such a thing as “leverage” (operating and financial).

Definition

So, production leverage represented by the ratio between variable and fixed costs that affect operating profit, which excludes taxes and interest. When a significant amount of fixed costs to a business entity operating leverage inherent in the high level, resulting in small changes in production volumes, a significant change to operating profit.

In Other words, the effect of the industrial lever is also apparent in the generation of strong changes of profit to any amendments to the proceeds from the sale.

The Reason along with the term “leverage” in this article it is used a synonym for – “lever”. Indeed, in English the word leverage means “lever”.

Thus, the production leverage (operating – its other name) is a mechanism of effective management of the profit of any economic entity, which is based on the improvement in the ratio between variable and fixed costs. With the help of this indicator it becomes possible to plan for any changes in profit the company depending on changes in sales volumes. In this case, can be calculated the break-even point.

Classification of costs

A Necessary condition, which can be used operating leverage (leverage), - application of the margin method based on the division of all costs into variables and constants.

So, the higher the proportion of fixed costs in the total costs of the entity, the less will change the amount of profit in relation to the rate of change of sales.

Returning to the classification of expenditure, it should be noted that their level (e.g., fixed costs) in the company's revenue has a significant impact on the trend of changes of the magnitude of costs or profits. This is due to the fact that the additional yield is going to cover fixed charges, is formed from an additional unit of output. The growth of total income from such additional unit of finished product (or commodity) is a change amount of profit. When you reach the break-even point the profit is formed, which is characterized by more rapid growth than sales.

The Effect of operating leverage

This operating lever is a quite effective tool in identifying and analysing the above dependence. In other words, its main purpose is to establish the impact of profit to any changes in sales volumes.

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The Essence of its action – and the increase in revenue contributes to a higher amount of profit. However, this growth rate can be limited from the variable and fixed costs. Economists proved that the higher the proportion of fixed costs, the higher the restriction.

Operational leverage (operational) quantitatively characterized by comparison of fixed and variable costs in the total value of this economic indicator as profit before interest and taxes. Known types of levers: price and natural.

Calculate production operating leverage, it is possible with sufficient accuracy to predict any change of profit under different changes in the amount of revenue.

For greater understanding of this economic indicator it is necessary to consider the procedure of calculation.

Operating leverage

Calculation Formula of the production lever is quite simple: the ratio of revenues and profits from the sale.

Considering the revenue as the sum of the costs (variable and fixed) and of profit, we can understand that the formula for calculating operating leverage will be as follows:

Ol = (Ol + Car + Cost)/PR = 1 + Rper/PR + Cost/PR.

Assessment of operating leverage is not percentages, as this indicator presents the ratio of contribution margin to profit. Due to the fact that marginal income, other than earnings, is also the sum of fixed costs, the value of the production lever always greater than one.

Operating leverage as an indicator of activity of the enterprise

The Value of this indicator is display the riskiness not only of the business entity itself, but also the type of business, which he does. This is due to the fact that the ratio of expenditures in the structure of all costs – a reflection of not only the characteristics of the company with its accounting policy, but also individual peculiarities of its business.

Economists proved that the high level of fixed costs in the total cost structure of a business entity is not always a negative phenomenon. This is due to the fact that just to absolute value of marginal income is impossible. The increasing level of operating leverage shows the total power production capacitythe company technical re-equipment, increase of labour productivity. The profit of a business entity with high level of the production lever is too sensitive to any changes in the revenue value. With a sharp drop in sales of the company “falls” below the limit of break-even. In other words, a company with a very high value of leverage – risky.

Characteristics of other economic levers

In the economic literature one can find simultaneous use of indicators such as operational and financial leverage. In this case, if the operating lever characterizes the dynamics of profit depending on changes in the amount of sales, then financial leverage is characterized by changes in the value of profits net of interest payments on loans and credits in response to changes in operating profit.

There is another economic indicator – a total lever, which combines the operating and financial leverage and shows how (how many percentage points) changes in net profit after interest payments with changes in earnings by one percent.

Credit (financial) leverage

This economic indicator represents the ratio of own and borrowed capital of the enterprise and its impact on the profit. With the increase in the share of borrowed capital decreases the value of net profit. This is due to the growth of expenses for payment of percent on loans.

The value of the ratio of debt to equity indicates the level of risk (financial stability). A company with a high level of borrowings – financially dependent company. If the company finances its own business activities only through equity, then it can be classified as financially independent companies.

Payment for the use of borrowed capital is often lower than the profit, which is provided by it additionally. Specified additional profit can be added to the profit obtained with the use of own capital, thus increasing the profitability.

Tasks

For a full analysis of this economic indicator should be listed on the tasks solved with the help of this operating leverage:

• Determination of the financial result in the whole enterprise and for individual products on the basis of “costs – volume – profit”;
• Calculation of the critical production point, using it when making certain management decisions, as well as with the establishment cost of works;
• Decision-making on the implementation of additional orders and review them for possible appreciation in the part of the fixed costs;
• Consideration of the question of cessation of production of certain types of goods when the price falls below the level of variable costs;
• Profit maximization due to the relative reduction of fixed costs;
• Using a profitable level with the development of production programs, establishing prices for goods.

Conclusion

In summary, it should be noted that the operating lever can be increased through borrowing. And very high production leverage can be offset by using financial leverage. Discussed in this article are effective economic instruments contribute to achieving the necessary return on investment with controlled risk.