In the economic literature quite often there is such a thing as “leverage” (operational and financial).
Definition
So, production leverage is represented by the ratio of variable and fixed costs of the enterprise, affecting operating profit, which is determined without taxes and interest.
With a significant amount of fixed costs, a business entity is characterized by a high level of operating leverage, which, with small changes in production volumes, leads to significant changes in operating profit.
In other words, the effect of such production leverage also manifests itself in the generation of strong changes in profit with any changes in sales revenue.
For good reason, along with the term “leverage”, this article uses its synonym - “leverage”. Indeed, translated from English leverage means "leverage".
Thus, production leverage (operational - its other name) is a mechanism for the effective management of profit of any business entity, which is based on improving the ratio of variables and fixed costs. Using this indicator, it becomes possible to plan any changes in profit at the enterprise depending on changes in sales volumes. In this case, the breakeven point can be calculated.
Cost classification
A necessary condition under which the operating lever (leverage) can be used is the application of the marginal method, based on the separation of all expenses into variables and constants.
So, the higher the share of fixed costs in the total costs of a business entity, the less will change the size of profit in relation to the rate of change in revenue of the enterprise.
Returning to the classification of expenses, it should be noted that their level (for example, fixed costs) in the company's revenue has a significant impact on the trend in costs or profits. This is due to the fact that additional profitability, which goes to cover fixed costs, is formed from an additional unit of production. Moreover, the increase in total income from such an additional unit of finished goods (or goods) is expressed in a change in the amount of profit. Upon reaching the breakeven level, profit is formed, which is characterized by faster growth than sales.
The effect of operational leverage
This operational lever serves as a rather effective tool in determining and analyzing the above dependence. In other words, its main purpose is to establish the effect of profit on any changes in sales volumes.
The essence of its action - an increase in revenue contributes to a greater increase in the amount of profit. Moreover, this growth rate may be limited by variable and fixed costs. Economists have proven that the higher the proportion of fixed costs, the higher its limitation.
Production leverage (operational) in quantitative terms is characterized by a comparison of fixed and variable costs in their total amount with the value of such an economic indicator as profit before interest and taxes. The following types of leverage are known : price and natural.
By calculating production operating leverage, one can predict with sufficient accuracy any change in profit for various changes in the amount of revenue.
For a better understanding of this economic indicator, it is necessary to consider the procedure for its calculation.
Operating leverage
The formula for calculating production leverage is quite simple: the ratio of revenue to profit from sales.
Considering revenue as the sum of costs (variables and fixed) and profit, we can understand that the formula for calculating operating leverage will take the following form:
Ol = (Pr + Rper + Rpost) / Pr = 1 + Rper / Pr + Rpost / Pr.
Operational leverage is not estimated as a percentage, since this indicator is represented by the ratio of marginal income to profit. Due to the fact that the marginal income, in addition to profit, also includes the amount of fixed costs, the value of production leverage is always higher than one.
Operating leverage as an indicator of enterprise performance
The value of this indicator is considered to reflect the riskiness of not only the business entity, but also the type of business in which it is engaged. This is due to the fact that the ratio of costs in the structure of all costs is a reflection not only of the characteristics of the enterprise with its accounting policy, but also of individual industry-specific features of its economic activities.
Economists have proved that a high level of fixed costs in the general cost structure of a business entity is not always a negative phenomenon. This is due to the fact that it is impossible to simply absolutize the amount of marginal income. The increasing level of operational leverage shows the increase in the total production capacity of the company, technical re-equipment, and increased labor productivity. The profit of a business entity with a high level of production leverage is too sensitive to any changes in the value of revenue. With a sharp drop in sales, this company quickly "falls" below the breakeven point. In other words, an enterprise with a very high leverage is risky enough.
Description of other types of economic leverage
In the economic literature, one can find the simultaneous use of indicators such as operational and financial leverage. Moreover, if the operating leverage characterizes the dynamics of profit depending on changes in the amount of the company's revenue, then financial leverage already characterizes the changes in the value of profit minus interest payments on loans and credits in response to changes in operating profit.
There is another economic indicator - the aggregate leverage that combines operational and financial leverage and shows how (by how many percentage points) changes in profit will occur after interest is paid with one percent change in revenue.
Credit (financial) leverage
This economic indicator represents the ratio of own and borrowed capital of the enterprise, as well as its impact on profit.
With an increase in the share of borrowed capital, the value of net profit decreases. This is due to an increase in the cost of paying interest on loans.
The ratio of borrowed to equity shows the level of risk (financial stability). An enterprise with a high level of borrowed funds is a financially dependent company. If the company finances its own economic activities only at the expense of equity, then it can be classified as financially independent companies.
Payment for the use of borrowed capital is often lower than the profit, the receipt of which is provided to them additionally. The specified additional profit can be summed up with profit obtained using equity capital, which contributes to an increase in profitability ratio.
Tasks to be Solved
For a complete analysis of this economic indicator, it is necessary to list the tasks that can be solved with the help of this operational leverage:
- determination of the financial result as a whole for the enterprise, and for individual types of products using the scheme "costs - volumes - profit";
- calculation of a critical production point using it when making certain management decisions, as well as determining the cost of work;
- making decisions on the implementation of additional orders and considering them for possible cost increases in terms of fixed costs;
- consideration of the issue of stopping the production of certain types of goods when prices fall below the level of variable costs;
- profit maximization due to the relative reduction in fixed costs;
- use of profitability with the development of production programs, setting prices for goods.
Conclusion
Summing up, it should be noted that the operating leverage can be increased by borrowing funds. A very high production leverage can be leveled using financial leverage. Such effective economic instruments considered in this article contribute to the achievement by the enterprise of the necessary return on invested funds with risk level control.