Leverage Notes

In: Business and Management

Submitted By devrishivijan
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Leverage arises from the presence of fixed costs in a firm’s cost structure. Two types of leveragea) Operating Leverage and b) Financial Leverage. •Operating leverage arises from fixed operating costs (depreciation, salaries, advertisement etc).
•Financial leverage from the presence of fixed financing costs such as interest.

Concepts that enhance our understanding of risk...
1) Operating Leverage - affects a firm’s business risk.

2) Financial Leverage - affects a firm’s financial risk.

Operating Leverage
The use of fixed operating costs as opposed to variable operating costs. A firm with relatively high fixed operating costs will experience more variable operating income if sales change. So it is the responsiveness of the firm’s EBIT to fluctuations in sales.

• Suppose the firm has both fixed operating costs (administrative salaries, insurance, rent, property tax) and variable operating costs (materials, labor, energy, packaging, sales commissions).

Total Revenue



Total Cost


Breakeven point






Operating Leverage
• What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?

Total Revenue




Total Cost = Fixed


New Breakeven Point with FC

Old Breakeven Point with VC &FC


With high operating leverage, an increase in sales produces a relatively larger increase in operating income.
Trade-off: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed expenses!

Breakeven Calculations
Breakeven point (units of output): BEP (Q) = F/(P – V)  F = total anticipated fixed costs.  P = sales price per unit.  V = variable cost per unit.
Breakeven point (sales rupees):

BEP (sales revenue) = F/(1- (VC/S))
 F…...

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