Topics: Operating leverage, Leverage, Costs Pages: 4 (760 words) Published: August 25, 2013

Leverage is generally defined as the ratio of the percentage change in profits to the percentage change in sales. In other words, leverage is the multiplying effect that fixed costs have on profits when there is any change in sales. As sales increases or decreases, it is only the variable costs that change correspondingly, fixed costs remain constant. Profits therefore increase or decrease at a faster rate than the rate of change in sales. This can be better understood with an example.

A hypothetical income statement for a firm is as follows:

Less: Variable costs 800
Contribution 1200
Less: Fixed costs 500
Profits 700

If the sales of this firm is increased by 20%, the income statement will stand revised as follows:

Sales2500 (increase of 25%)
Less: Variable costs1000 (increase of 25%) ------
Contribution 1500 (increase of 25%)
Less: Fixed costs 500 (No change)
Profits 1000

With an increase in sales of 25% from Rs. 2,000 to Rs. 2,500, profits have increased from Rs. 700 to Rs. 1000, an increase of 43%. This is the effect of leverage. If the firm had no fixed costs at all but all its costs were variable, there would have been no leverage and the percentage change in sales would have been the same as the percentage change in profits. It is fixed costs that introduce leverage into the firm and higher the fixed cost, higher is the leverage.

Financial management differentiates between two types of leverages – Operating leverage and financial leverage.

Operating leverage is the leverage effect on account of all fixed costs other than interest and financial leverage is the leverage effect on account of the financial cost, interest.

The formulae for calculating the...
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