Foundations of Financial Management: An Analysis (part 12)

Money is a terrible master but an excellent servant.

P.T. Barnum

Operating and Financial Leverage

by

Charles Lamson

 Leverage in a Business

Assume you are approached with an opportunity to start your own business. You are to manufacture and market industrial parts, such as ball bearings, wheels, and casters. you are faced with two primary decisions.

First, you must determine the amount of fixed cost planned and equipment you wish to use in the production process. By installing modern, sophisticated equipment, you can virtually eliminate labor in the production of inventory. At high volume, you will do quite well, as most of your costs are fixed. At low volume, however, you could face difficulty in making your fixed payments for plant and equipment. If you decide to use expensive labor rather than machinery, you will lessen your opportunity for profit, but at the same time you will lower your exposure to risk (you can lay off part of the workforce).

Second, you must determine how you will finance the business. If you rely on debt financing and the business is successful, you will generate substantial profits as an owner, paying only the fixed costs of debt. Of course, if the business starts off poorly, the contractual obligations related to debt could mean bankruptcy. As an alternative, you might decide to sell equity rather than borrow, a step that will lower your own profit potential (you must share with others) but minimize your risk exposure.

In both decisions, you are making very explicit decisions about the use of leverage. To the extent that you go with a heavy commitment to fixed costs in the operation of the firm, you are employing operating leverage. To the extent that you utilize debt in the financing of the firm, you are engaging in financial leverage. We shall carefully examine each type of leverage and then show the combined effect of both.

Operating Leverage

Operating leverage reflects the extent to which fixed assets and associated fixed costs are utilized in the business. As indicated in Table 1, a firm's operational costs may be classified as fixed, variable, or semi variable.

Table 1   Classification of costs

For purposes of analysis, variable and semivariable costs will be combined. In order to evaluate the implications of heavy fixed asset use, we employ the technique of break-even analysis.

Break-Even Analysis

How much will changes in volume affect cost and profit? At what point does the firm break even? What is the most efficient level of fixed assets to employ in the firm? A break-even chart is presented in Figure 1 to answer some of these questions. The number of units produced and sold as shown along the horizontal axis, and revenue and costs are shown along the vertical axis.

Figure 1

Note, first of all, that our fixed costs are $60,000, regardless of volume, and that our variable costs at $0.80 per unit are added to fixed costs to determine total cost at any point. The total revenue line is determined by multiplying price ($2) times volume.

Of particular interest is the break-even be point at 50,000 units, where the total cost and total revenue lines intersect. The numbers are as follows:

The break-even point for the company may also be determined by use of a simple formula---in which we divide fixed costs by the contribution margin on each unit sold, with the contribution margin defined as price minus variable cost per unit. The formula is shown below.

Formula 1

Since we are getting a $1.20 contribution toward covering fixed costs from each unit sold, minimum sales of 50,000 units will allow us to cover our fixed costs (50,000 units X $1.20 equals $60,000 fixed costs). Beyond this point, we move into a highly profitable range in which each unit of sales brings a profit of $1.20 to the company. As sales increase from 50,000 to 60,000 units, operating profits increase by $12,000 as indicated in Table 2; as sales increase from 60,000 to 80,000 units, profits increase by another $24,000; and so on. As further indicated in Table 2, at low volumes such as 40,000 or 20,000 units our losses are substantial ($12,000 and $36,000 in the red).

Table 2 Volume-cost-profit analysis: Leveraged firm

It is assumed that the firm depicted in Figure 1, as previously presented, is operating with a high degree of leverage. The situation is analogous to that of an airline that must carry a certain number of people to break even, but beyond that point is in a very profitable range.

A More Conservative Approach

Not all firms would choose to operate at the high degree of operating leverage exhibited in Figure 1. Fear of not reaching the 50,000 unit break-even level might discourage some companies from heavy utilization of fixed assets. More expensive variable costs might be substituted for automated plant and equipment. Assume fixed costs for a more conservative firm can be reduced to $12,000 but variable costs will go from $0.80 to $1.60 if the same price assumption of $2 per unit is employed, the break-even level is 30,000 units.

Figure 2

Even at high levels of operation, the potential profit in Figure 2 is rather small. Located in Table 3 (below), at a 100,000 unit volume, operating income is only $28,000 some $32,000 less than that for the leveraged firm previously analyzed in Table 2.

Table 3 Volume-cost-profit analysis: Conservative firm

The Risk Factor

Whether management follows the path of the leveraged firm or of the more conservative firm depends on its perceptions about the future. If the vice president of finance is apprehensive about economic conditions, the conservative plan may be undertaken. For a growing business in times of relative prosperity, management might maintain a more aggressive, leveraged position. The firm's competitive position within its industry will also be a factor. Does the firm desire to merely maintain stability or to become a market leader? To a certain extent, management should tailor the use of leverage to meet its own risk-taking desires. Those who are risk-averse (prefer less risk to more risk) should anticipate particularly high return before contracting for heavy fixed costs. Others, less averse to risk, may be willing to leverage under more normal conditions. Simply taking risk is not a virtue---our prisons are full of risk takers. The important idea, which is stressed throughout this analysis, is to match an acceptable return with the desired level of risk. 

Cash Break-Even Analysis

Our discussion to this point has dealt with break-even analysis in terms of accounting flows rather than cash flows. For example, depreciation has been implicitly included in fixed expenses, but it represents a non-cash accounting entry rather than an explicit expenditure of funds. To the extent that we were doing break-even analysis on a strictly cash basis, depreciation would be excluded from fixed expenses. In the previous example of the leveraged firm in Formula 1, if we eliminate $20,000 of "assumed" depreciation from fixed costs, the break-even level is reduced to 33,333 units.

Other adjustments could also be made for non-cash items. For example, sales may initially take the form of accounts receivable rather than cash, and the same can be said for the purchase of materials and accounts payable. An actual weekly or monthly cash budget would be necessary to isolate these items.

While cash break-even analysis is helpful in analyzing the short-term outlook of the firm, particularly when it may be in trouble, break-even analysis is normally conducted on the basis of accounting flows rather than strictly cash flows. Most of the assumptions throughout this and the next few posts are based on concepts broader than pure cash flows.

Degree of Operating Leverage

Degree of operating leverage (DOL) may be defined as the percentage change in operating income that occurs as a result of a percentage change in the units sold.

Formula 2

Highly leveraged firms, such as Ford Motor Company or Dow Chemical, are likely to enjoy a rather substantial increase in income as volume expands, while more conservative firms will participate in an increase to a lesser extent. Degree of operating leverage should be computed only over a profitable range of operations. However, the closer DOL is computed to the company break-even point, the higher the number will be due to a large percentage increase in operating income.

Let us apply the formula to the leveraged and a conservative firms previously discussed. Their income or losses at various levels of operations are summarized in Table 4.

Table 4

We will now consider what happens to operating income as volume moves from 80,000 to 100,000 units for each firm. We will compute the degree of operating leverage (DOL) using formula 2 (see above).

Leveraged Firm 

Conservative Firm 

We see above that the DOL is much greater for the leveraged firm, indicating at 80,000 units a 1% increase in volume will produce a 2.7 percent change in operating income, versus a 1.6 percent increase for the conservative firm.

The formula for degree of operating leverage may be algebraically manipulated to read:

We once again derive an answer of 2.7. The same type of calculation could also be performed for the conservative firm.

Limitations of Analysis

Throughout our analysis of operating leverage, we have assumed that a constant or linear function exists for revenues and costs as volume changes. For example, we have used $2 as the hypothetical sales price at all levels of operation. In the real world, however, we may face price weakness as we attempt to capture an increasing market for our product, or we may face cost overruns as we move beyond an optimum-size operation. Relationships are not so fixed as we have assumed.

Nevertheless, the basic patterns we have studied are reasonably valid for most firms over an extended operating range (in our example that might be between 20,000 and 100,000 units). It is only at the extreme levels that linear assumptions fully breakdown, as indicated in Figure 3. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 114-121*

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