Analysis of various financial and economic indicators is the most important component of the management process entrepreneurial activity. Only knowing the numbers can an entrepreneur or manager fully engage in management activities and accept rational decisions. In one article it is simply impossible to analyze all the coefficients characterizing the activities of an enterprise. Today we will look at only one very important indicator - operating leverage. Namely, we will try to understand what it is, how to calculate it and, most importantly, why.
What is financial and operating leverage
The most complete understanding of what it is operating leverage can only arise in the case of a comprehensive study of other coefficients for analyzing the financial and economic activities of an enterprise. But here we note that this indicator is one of the main mechanisms for managing the parameters of profitability (primarily profit) of an enterprise. Key Principle put into the formation of this indicator is the optimization of the relationship between constants and variable costs enterprises.
The last remark is due to the fact that variable and fixed costs, or more precisely, their ratio, have a direct impact on the dynamics of income (revenue and profit). For example, in other articles on our website you can read about how the amount of fixed costs changes as part of the cost depending on changes in the volume of production of goods and services; or about what features the variable costs of an enterprise have.
Thus, when income increases as a result of an increase in output, and the amount fixed costs remains unchanged, there is, in fact, an automatic increase in the company’s profit due to such a “stretching” of fixed costs over the entire increased production volume.
What characterizes operating leverage
From the above it follows that operating leverage is the main characteristic for determining the optimal dynamics of an enterprise’s profit depending on the volume of production and sales of products. Operating leverage is inextricably linked with such a parameter of investment analysis as the break-even point.
Analysis of the relationship between variable and fixed costs helps in planning the dynamics of changes in profit and revenue of an enterprise. In other words, operating leverage allows you to analyze the relationship between changes in production volume and the profit of the enterprise received during the sale of manufactured products.
For example, using operating leverage, you can trace the following relationship: as revenue increases, more fast growth profit, which depends on the ratio of direct and overhead costs. If the share of fixed costs in the cost structure is relatively small, then the growth rate of profit relative to the growth rate of revenue will be higher.
Determining operating leverage, like other parameters of investment analysis, is the central core when drawing up a business plan for any project. It is necessary not only to calculate these parameters, but also to do this within the framework of a single financial model, and then integrate it into the overall structure of the business plan. Therefore, if you plan to design a future enterprise yourself, we advise you to still download the sample ready-made business plan for an enterprise similar to yours, which will become a kind of guideline in this difficult process.
Formula for calculating operating leverage (in monetary terms)
As with many other parameters, there are two calculation options for operating leverage - in monetary terms and in physical terms. First, let's look at how to calculate operating leverage in monetary terms. Formula in in this case will look like this:
Operating leverage = Revenue/Profit.
It is important to note that the amount of revenue and profit in this case assumes only income received during the sale (sale) of goods or services. Another note is that it is worth remembering that revenue is the sum of such parameters as the amount of profit (trading margin), fixed and variable costs. From here it becomes possible to conduct marginal (related to fixed and variable costs) analysis to determine the optimal cost structure, break-even point, planning changes in profit, etc.
Taking into account the above, we can modify the formula operating leverage in the following way:
Operating leverage = (Profit + Fixed costs + Variable costs) / Profit = 1 + Fixed costs / Profit + Variable costs / Profit.
Formula for calculating operating leverage (in physical terms)
Formula for calculation operating leverage in physical terms is sometimes also called production leverage. This indicator is calculated as follows:
Operating leverage = (Revenue - Variable costs) / Profit
Operating leverage = (Profit + Fixed costs)/Profit = 1 + Fixed costs/Profit. The resulting number is a coefficient in absolute terms, which shows the relationship between marginal income and the amount of profit from the sale of goods or services.
In order to check whether you have made any serious mistakes, you can consider that the value operating leverage and will always be greater than one. This is explained by the fact that the amount of marginal income includes not only the amount of profit, but also the amount of fixed costs.
How is operating leverage used to plan an enterprise's activities?
Of course, business planning is not limited to just calculating investment parameters. It will be necessary to assess the general socio-economic situation, the competitive advantages of a product or service, and develop a marketing program for its promotion, and a number of other sections. But determining the operating leverage and break-even point is the central link that will allow you to determine, even before the start of production, whether the project is feasible in principle.
- Firstly, operating leverage allows you to determine the critical point (volume) of production and, based on this, make decisions about the advisability of further activities;
- Secondly, leverage helps in calculating the financial result for the organization as a whole, as well as by type of product, work or service based on the cost-volume-profit scheme;
- Thirdly, when we make a decision to expand production, introduce new products, etc. you need to understand how much the company’s income will increase during such modernization. Here again we cannot do without a definition operating leverage.
- Fourthly, operating leverage is the basis for determining the profitability threshold when drawing up production programs and setting prices for goods, work or services.
- And finally, production leverage characterizes the relationship between such important parameters as the cost structure, the volume of production and sales of goods and services and the profit of the enterprise. This parameter also shows the change in profit depending on changes in sales volumes.
Conclusions: the impact of operating leverage on the efficiency of business processes
Thus it becomes clear that operating leverage is one of the main parameters characterizing the efficiency of an enterprise. After all, such parameters as “Revenue”, “Profit”, “Cost”, “Fixed costs”, “Variable costs”, “Break-even point”, etc. are of paramount importance for tracking the dynamics of enterprise development. A operating leverage in turn, becomes the very indicator that, to one degree or another, unites all the named quantities. Therefore, it is important to determine the value operating leverage still at the planning stage of the future enterprise.
In order to save your effort and time, we advise you to download in advance a sample of a ready-made business plan for an enterprise operating in the same industry. The clear structure of this document, as well as a ready-made financial model, will allow you to take into account all the necessary aspects of business planning and automatically calculate most financial indicators. If you doubt that you can independently develop a business plan for your project, we advise you to contact professionals who will handle business planning in a turnkey format and taking into account all the individual characteristics of your business.
Dividing the totality of production expenses (operating costs) of an enterprise into constant and variable ones allows, when generating sales profit (operating profit), to also use the mechanism of “operational (production) leverage.” The operation of this mechanism is based on the fact that if operating costs contain fixed costs, it leads to the fact that when the volume of product sales changes, the amount of operating profit always changes at an even higher rate.
Fixed operating costs (costs) cause a disproportionately higher change in the amount of operating profit of an enterprise with any change in the volume of product sales, regardless of the size of the enterprise, industry characteristics and other factors. However, the higher the share of fixed costs in the total operating costs of the enterprise, the more the amount of operating profit changes in relation to the rate of change in the volume of product sales.
The ratio of fixed and variable operating costs of an enterprise is characterized by the “operating leverage ratio,” which is calculated using the following formula:
Kol = Hypost / Io, (30)
where Kol is the operating leverage ratio;
And post is the sum of fixed transaction costs;
Io is the total amount of transaction costs.
The higher the value of the operating leverage ratio at an enterprise, the more it is able to accelerate the growth rate of operating profit in relation to the growth rate of product sales; that is, at the same rate of growth in product sales, an enterprise that has a higher operating leverage ratio, other things being equal, will always increase the amount of its operating profit to a greater extent in comparison with an enterprise with a lower value of this ratio.
The specific ratio of the increase in the amount of operating profit and the amount of sales volume, achieved at a certain operating leverage ratio, is characterized by the “operating leverage effect” indicator. This indicator is calculated using the formula:
Eol= tVOP / tOP, (31)
where Eol is the effect of operational leverage achieved at a specific value of its coefficient at the enterprise;
By setting a particular growth rate in the volume of product sales, you can determine how the amount of operating profit will increase given the operating leverage ratio established at the enterprise. Differences in the achieved effect at different enterprises will be determined by differences in the ratio of their fixed and variable operating costs, reflected by the operating leverage ratio.
The above fundamental formula for calculating the effect of operating leverage has a number of modifications.
Thus, the effect of operating leverage can be expressed by the following formulas:
Eol = tMP/tOR; (38) Eol = tMP / tVOP, (39)
TMP - growth rate of marginal operating profit, %;
tGOP - growth rate of gross operating profit, %;
TOP - growth rate of product sales volume, %.
In order to eliminate the impact of tax payments included in the price of products and paid at the expense of gross income, the calculation of the effect of operating leverage can be made using the following formula:
Eol = tVOP / tCHOD, (40)
where Eol is the effect of operating leverage;
tGOP - growth rate of gross operating profit, %;
tCHOD - growth rate of net operating income, %
To separately study the impact on operating profit of an increase in product sales in physical terms and changes in the price level for it, the following formula is used to determine the effect of operating leverage:
Aeolus = tBOP / tORn * tCe (41)
where Eol is the effect of operating leverage;
tGOP - growth rate of gross operating profit, %;
tORn - growth rate of product sales volume in physical terms (number of product units), %;
tCe - rate of level change average price per unit of production, %.
This formula allows you to comprehensively take into account the impact on changes in the amount of operating profit of both the operating leverage ratio and changes pricing policy.
Was discussed above general principle operation of the operating leverage mechanism. At the same time, in specific situations operating activity of an enterprise, the manifestation of the operating leverage mechanism has a number of the following features that must be taken into account in the process of its use:
1. The positive impact of operating leverage begins to appear only after the enterprise has passed the break-even point of its operating activities. In order for the positive effect of operating leverage to begin to manifest itself, the enterprise must first receive a sufficient amount of marginal profit to cover its fixed operating expenses (i.e., ensure equality: MP = Hypost). This is due to the fact that the enterprise is obliged to reimburse its fixed operating costs regardless of the specific volume of product sales, therefore, the higher the amount of fixed costs and the operating leverage ratio, the later, other things being equal, it will reach the break-even point of its activities. In this regard, until the enterprise has achieved break-even in its operating activities, a high operating leverage ratio will be an additional “burden” on the way to achieving the break-even point.
2. After overcoming the break-even point, the higher the operating leverage ratio, the greater the power of influence on profit growth the enterprise will have, increasing the volume of product sales.
At the same rate of growth in the volume of product sales at an enterprise with a higher operating leverage ratio, the amount of operating profit increases at a higher rate after overcoming the break-even point than at an enterprise with a lower operating leverage ratio.
3. The greatest positive impact of operating leverage is achieved in the field as close as possible to the break-even point (after it has been overcome). As the volume of product sales continues to increase and moves away from the break-even point (i.e., as the safety margin or safety margin increases), the effect of operating leverage begins to decrease; i.e., each subsequent percentage increase in product sales volume will lead to an ever-lower growth rate in the amount of operating profit (but at the same time, the growth rate in the amount of profit will always remain greater than the growth rate in product sales volume).
4. The mechanism of operating leverage also has the opposite direction - with any decrease in the volume of product sales, the size of the gross operating profit will decrease to an even greater extent. Moreover, the proportions of such a reduction depend on the value of the operating leverage ratio: the higher this value, the faster the amount of gross operating profit will decrease in relation to the rate of decline in product sales. Likewise, as you approach the break-even point in the opposite direction, the negative effect of the rate of decline in profits relative to the rate of decline in product sales will increase. The proportionality of the decrease or increase in the effect of operating leverage with a constant value of its coefficient allows us to conclude that the operational leverage ratio is a tool that equalizes the ratio of the level of profitability and the level of risk in the process of carrying out operating activities.
5. The effect of operating leverage is stable only in the short term. This is determined by the fact that operating costs, classified as fixed costs, remain unchanged only for a short period of time. As soon as, in the process of increasing the volume of product sales, another jump in the amount of fixed operating costs occurs, the enterprise needs to overcome the new break-even point or adapt its operating activities to it. In other words, after such a jump, which causes a change in the operating leverage ratio, its effect manifests itself in a new way in new business conditions.
Understanding the mechanism of manifestation of operational leverage allows you to purposefully change the ratio of fixed and variable costs in order to increase the efficiency of operating activities. This change comes down to a change in the value of the operating leverage ratio for different trends in the product market conditions and stages life cycle enterprises.
In case of unfavorable conditions on the commodity market, which determines a possible decrease in the volume of product sales, as well as early stages life cycle of an enterprise, when it has not yet overcome the break-even point, it is necessary to take measures to reduce the value of the operating leverage ratio. And vice versa, with favorable conditions on the commodity market and the presence of a certain margin of safety (margin of safety), the requirements for the implementation of a regime for saving fixed costs can be significantly weakened - during such periods, an enterprise can significantly expand the volume of real investments by reconstructing and modernizing production fixed assets.
Changing the value of operating leverage can be achieved by influencing both fixed and variable operating costs.
The high level of fixed costs is largely determined by industry characteristics that determine different levels of capital intensity of manufactured products, differentiation of the level of mechanization and labor automation. In addition, fixed costs are less amenable to rapid change, so enterprises with a high operating leverage ratio lose flexibility in managing their costs.
However, despite these objective limitations, each enterprise has sufficient opportunities to reduce, if necessary, the amount and specific gravity fixed operating costs. Such reserves include a significant reduction in overhead costs (management costs) in the event of unfavorable commodity market conditions; sale of part of unused equipment and intangible assets in order to reduce the flow of depreciation charges; widespread use of short-term forms of leasing of machinery and equipment instead of purchasing them as property; reduction in the volume of a number of consumed utilities and some others.
When influencing variable costs, it is necessary to ensure their constant savings, because There is a direct relationship between the amount of these costs and the volume of production and sales of products. Saving variable costs before the enterprise overcomes the break-even point leads to an increase in the amount of marginal profit, which allows it to quickly overcome this point. Once the break-even point is passed, the amount of variable cost savings will provide a direct increase in gross operating profit. The main reserves for saving variable costs include reducing the number of workers in main and auxiliary production by ensuring an increase in their labor productivity; reducing the size of stocks of raw materials, supplies, and finished products during periods of unfavorable commodity market conditions; ensuring favorable terms for the enterprise for the supply of raw materials and materials, and others.
A targeted change in the ratio of fixed and variable costs, under changing economic conditions, allows us to increase the potential for the formation
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Operating leverage, while helping to increase profits, simultaneously increases risks - instability of profits and higher critical profitability.
Operating leverage is used by managers to balance different kinds costs and increase income accordingly.
Operating leverage makes it possible to increase profits when the ratio of variable and fixed costs changes. Increase in operating leverage, i.e. An increase in the share of fixed costs leads to an increase in profits.
Operating leverage makes it possible to increase profits when the ratio of variable and fixed costs changes.
Operating leverage can increase profits. However, to obtain benefits, the company must accept certain risks, namely, instability of profits and higher critical profitability.
Operating leverage is characterized by the ratio between fixed and variable expenses in their total amount. If the share of fixed expenses is large, the company is said to have high level operating leverage. So, the variability of sales profit due to changes in operating leverage quantifies production risk.
The effect of operating leverage is stable only in the short term. This is determined by the fact that operating costs, classified as fixed costs, remain unchanged only for a short period of time. As soon as, in the process of increasing the volume of product sales, another jump in the amount of fixed operating costs occurs, the enterprise needs to overcome the new break-even point or adapt its operating activities to it. In other words, after such a jump, which causes a change in the operating leverage ratio, its effect no - new manifests itself in new business conditions.
The mechanism of operating leverage also has the opposite direction - with any decrease in the volume of product sales, the amount of gross operating profit will decrease to an even greater extent. Moreover, the proportions of such a decrease depend on the value of the operating leverage ratio: the higher this value, the faster the amount of gross operating profit will decrease. operating profit in relation to the rate of decline in product sales. Likewise, as you approach the break-even point in the opposite direction, the negative effect of the rate of decline in profits relative to the rate of decline in product sales will increase. The proportionality of the decrease or increase in the effect of operating leverage with a constant value of its coefficient allows us to conclude that the operational leverage ratio is a tool that equalizes the ratio of the level of profitability and the level of risk in the process of carrying out operating activities.
The effect of operating leverage is stable only in the short term. This is determined by the fact that operating costs, classified as fixed costs, remain unchanged only for a short period of time. As soon as, in the process of increasing the volume of product sales, another jump in the amount of fixed operating costs occurs, the enterprise needs to overcome the new break-even point or adapt its operating activities to it. In other words, after such a jump, which causes a change in the operating leverage ratio, its effect manifests itself in a new way in new business conditions.
The level of operating leverage, calculated as the ratio of semi-fixed costs to total costs, is twice as high in company B compared to company A.
The mechanism of operating leverage also has the opposite direction - with any decrease in the volume of product sales, the size of the gross operating profit will decrease to an even greater extent.
Operating leverage can be managed by influencing both fixed and variable operating costs.
Production or operating leverage is characterized by the relationship between sales revenue and sales profit. There is a multifaceted relationship between these indicators. An increase in revenue can be accompanied by both an increase and a decrease in profits. The study of factors influencing the increase in profit from the conditions for generating revenue relates to the field of application of industrial leverage.
What is operating leverage and what does it characterize?
The positive impact of operating leverage begins to appear only after the company has passed the break-even point of its operating activities. This is due to the fact that the enterprise is obliged to reimburse its fixed operating costs regardless of the specific volume of product sales, therefore, the higher the amount of fixed costs and the operating leverage ratio, the later, other things being equal, it will reach the break-even point of its activities.
AND . The influence of this ratio on the amount of profit from product sales can be traced from the figure.
Graph of the amount of profit depending on the ratio of fixed and variable costs
The figure shows two enterprises that, with the same volume of achieved sales of products ( R f) have the same amount of costs (current costs) and the same amount of net income. However, enterprise A has a ratio of fixed and variable costs of 2:1, and enterprise B has a ratio of 1:2, respectively. Due to the existing operating leverage (a high share of fixed costs in their total amount), enterprise A reaches the break-even point when selling products much later ( R TB), i.e. To reach this point, he needs to sell a much larger volume of products than enterprise B.
At the same time, with a further increase in the volume of product sales (after overcoming ) enterprise A will receive a large amount profit per unit of increase in production than enterprise B. This is due to the fact that due to fixed costs, their overall level in relation to the volume of product sales and net income at enterprise A will decrease to a greater extent (thereby increasing, ceteris paribus, the amount).
Operating leverage (operating leverage, production leverage) - the ratio of constant and variable expenses company and the impact of this ratio on operating profit, that is, earnings before interest and taxes. If the share of fixed costs is large, then the company has a high level of production leverage, while a small change in production volumes can lead to a significant change in operating profit.
The use of operating leverage allows you to manage future sales profits of an enterprise by planning future revenue. The main factors that influence revenue volume are:
- product price;
- variable costs;
- fixed costs.
Therefore, the goal of management is to optimize variable and fixed costs, regulate pricing policies to increase sales profits.
Price operating leverage is calculated using the formula:
R c = V/P R c = (P + Z lane + Z post)/P = 1+ Z lane / P + Z post / PWhere
IN- sales revenue;
P- revenue from sales;
Z lane- variable costs;
3 post- fixed costs;
R c- price operating leverage;
R n- natural operating leverage.
Natural operating leverage is calculated using the formula:
R n = (V - W lane)/PConsidering that B = P + Z lane + Z post, we can write:
R n = (P + G post)/P = 1 + G post /POperating leverage is used by managers to balance various types of costs and, accordingly, increase income.
Operating leverage makes it possible to increase profits when the ratio of variable and fixed costs changes.
Problems that are solved using operational leverage:
- calculation of the financial result for the organization as a whole, as well as for types of products, works or services based on the “costs – volume – profit” scheme;
- determining the production critical point and using it in acceptance management decisions and setting prices for work;
- making decisions on additional orders (answering the question: will an additional order lead to an increase in fixed costs?);
- making a decision to stop producing goods or providing services (if the price falls below the level of variable costs);
- solving the problem of maximizing profits through a relative reduction in fixed costs;
- using a threshold when developing production programs, setting prices for goods, work or services.
Introduction
1 The concept of leverage, its significance for a market economy
T Ermin "leverage" represents barbarism, i.e. direct borrowing of the American term « leverage» , already quite widely used in domestic specialized literature; Note that in the UK the term is used for the same purpose « Gearing». Some monographs use the term "lever arm", which should hardly be considered successful even in the linguistic sense, since in the literal translation in English the lever is “ lever", but not at all "1everge».
In economics, or more precisely in management under the word leverage understand – the process of managing the assets and liabilities of an enterprise aimed at increasing (increasing) profits.
The main performance indicator is the company's net profit, which depends on many factors, and therefore various factor decompositions of its changes are possible. In particular, it can be represented as the difference between revenue and expenses of two main types: production in nature and financial in nature. They are not interchangeable, but the amount and share of each of these types of expenses can be controlled. This representation of the factor structure of profit is extremely important in a market economy and freedom in financing a commercial organization with the help of loans from commercial banks, which vary significantly in the interest rates they offer.
From the position of financial management of the activities of a commercial organization, net profit depends on; firstly, on how rationally the financial resources provided to the enterprise are used, i.e. what they are invested in, and, secondly, on the structure of sources of funds.
The first point is reflected in the volume and structure of fixed and working capital and the efficiency of their use. The main elements of product cost are variable and fixed costs, and the relationship between them can be different and is determined by the technical and technological policy chosen by the enterprise. Changing the cost structure can significantly affect profit margins. Investing in fixed assets is accompanied by an increase in fixed costs and, at least in theory, a decrease in variable costs. However, the relationship is nonlinear, so finding the optimal combination of fixed and variable costs is not easy. This relationship is characterized by the category of production, or operational, leverage, the level of which determines, in addition, the amount of production risk associated with the company.
Leverage when applied to the financial sector, it is interpreted as a certain factor, a small change in which can lead to a significant change in the resulting indicators.
In financial management, the following are distinguished: types of leverage:
financial
production (operational)
production and financial
Every enterprise is a source of risk. In this case, the risk arises based on production and financial factors. These factors form the costs of the enterprise. Production and financial costs are not interchangeable, however, the amount and structure of production and financial costs can be controlled. This management occurs under conditions of freedom to choose sources of financing and sources of production costs. As a result of the use of various sources of financing, a certain ratio develops between equity and borrowed capital, and since borrowed capital is paid and generates financial costs, there is a need to measure the impact of these costs on the final result of the enterprise. Therefore, financial leverage characterizes the influence of the capital structure on the profit of the enterprise, and different ways of including credit costs in the cost affect the level of net profit and net return on equity.
2 Operational (production) leverage and its effect
Operational (production) leverage depends on the structure of production costs and, in particular, on the ratio of semi-fixed and semi-variable costs in the cost structure. Therefore, production leverage characterizes the relationship between the cost structure, output volume and sales and profit. Production leverage shows the change in profit depending on changes in sales volumes.
Operating leverage– this is a potential opportunity to influence balance sheet profit by changing the cost structure and production volume (fixed and variable costs, optimization).
Concept operating leverage associated with the cost structure and, in particular, with the relationship between semi-fixed and semi-variable costs. Consideration of the cost structure in this aspect allows, firstly, to solve the problem of maximizing profits through a relative reduction in certain expenses with an increase in the physical volume of sales, and, secondly, dividing costs into conditionally constant and conditionally variable allows us to judge the payback costs and provides the opportunity to calculate the margin of financial strength of the enterprise in case of difficulties, complications in the market, thirdly, it makes it possible to calculate the critical sales volume that covers costs and ensures break-even activity of the enterprise.
Solving these problems allows us to come to the following conclusion: if an enterprise creates a certain amount of semi-fixed expenses, then any change in sales revenue generates an even stronger change in profit. This phenomenon is called the effect of operating leverage.
For example: Let’s say that in the reporting year, sales revenue amounted to 10 million rubles. with total variable costs of 8.3 million rubles. and fixed costs 1.5 million rubles. Profit = 0.2 million rubles.
Let’s assume that in the planning year it is planned to increase revenue due to the physical volume of sales by 10%, i.e. 11 million rubles. Fixed expenses = 1.5 million rubles.
Variable expenses increase by 10%, i.e. 8.3*1.1=9.13 million rubles.
Profit from sales = 0.37 million rubles, i.e. 11-9.13-1.5.
Profit growth rate (370/200)*100 = 185%.
Revenue growth rate = 110%. For every increase in revenue, we have an increase in profit of 8.5%, i.e. EOL = 85%/10% = 8,5%
That. the strength (effect) of operational leverage can be considered as a characteristic of the business risk of an enterprise arising in a given area of business or in connection with its industry. And this effect can be measured as the percentage change in profit from sales after reimbursement of variable costs (or NREI) for a given percentage change in the physical volume of sales:
Where Q- physical sales volume,
R– price,
- revenues from sales,
– rate of variable costs for production,
– fixed costs
(5)
(6)
These formulas allow us to answer the question of how sensitive the marginal income is ( MD) to changes in production and sales volumes, and how much would be enough MD not only to cover fixed costs, but also to generate profits.
In connection with the concept of the effect of production leverage, the concept of a margin of financial strength arises ( ZFP), which ensures the profit of the enterprise, and the concept of the safety limit (break-even volume of production and sales or critical sales volume):
(8)
Where VRF– sales revenue (actual),
Critical volume in value terms,
ZFP– margin of financial strength.
The effect of operational leverage is related to different nature and the behavior of current costs of production and sales of products. Depending on the change in production volume X, variable costs and semi-fixed costs are distinguished, the study of which is the subject of break-even analysis.
The analytical representation of the break-even model is the break-even formula:
Revenue = Costs
All basic parameters are derived from this formula:
critical (break-even) production volume = profitability threshold;
critical value of the selling price;
critical value of fixed costs;
critical variable costs.
Break-even chart
Revenue
Total costs
Fixed costs
Rice. 1
For each of these parameters it is calculated margin of safety– this is the percentage ratio of the planned, or actual and critical value of the parameter. For production volume, this margin is called the margin of financial strength of the enterprise. It shows by what percentage, if the market situation changes, the volume of production can fall, up to critical.
Important concepts in production volume management are:
Contribution margin(marginal income) is the difference between price and unit variable costs.
Critical production volume– this is the quantity of products and the total marginal income from sales, which covers semi-fixed costs.
Sales volume in natural units ( X1), which provides a given gross income, calculated by the formula:
(11)
Where F.C.– fixed expenses,
- given gross income,
KM– contribution margin.
3 Leverage in manufacturing enterprises
Industrial leverage is a mechanism for managing enterprise profits, based on optimizing the ratio of fixed and variable costs. With its help, you can predict the profit of an enterprise depending on changes in sales volume, as well as determine the break-even point.
A condition for using the production leverage mechanism is the use of the marginal method, based on dividing costs into fixed and variable. The lower the share of fixed costs in the total costs of the enterprise, the more the profit changes in relation to the rate of change in the enterprise's revenue.
Production leverage is an indicator that helps managers choose the optimal enterprise strategy for managing costs and profits. The mechanism of production leverage is based on the change in the share of fixed costs in the total cost of the enterprise. The lower the share of fixed costs in the total costs of the enterprise, the more the amount of profit changes in relation to the rate of change in the enterprise's revenue.
The manifestation of the production leverage mechanism has the following features:
1) the positive impact of production leverage begins to appear only after the enterprise has overcome the break-even point of its activities.
For the positive effect of production leverage to begin to manifest itself, the company must first receive a sufficient amount of marginal income to cover its fixed costs. This is due to the fact that the company is obliged to reimburse its fixed costs regardless of the specific sales volume, therefore, the higher the amount of fixed costs, the later, other things being equal, it will reach the break-even point of its activities. In this regard, until the enterprise has achieved break-even for its activities, a high level of fixed costs will be an additional obstacle to achieving the break-even point;
2) as sales volume further increases and distance from the break-even point, the effect of production leverage begins to decline. Each subsequent percentage increase in sales volume will lead to an increasing rate of increase in the amount of profit;
3) the mechanism of production leverage also has the opposite direction - with any decrease in sales volume, the profit margin of the enterprise will decrease to an even greater extent;
4) there is an inverse relationship between production leverage and enterprise profit. The higher the profit of the enterprise, the lower the effect of production leverage, and vice versa. This allows us to conclude that production leverage is a tool that equalizes the ratio of the level of profitability and the level of risk in the process of carrying out production activities;
5) the effect of production leverage manifests itself only in a short period. This is determined by the fact that the enterprise’s fixed costs remain unchanged only for a short period of time. As soon as another jump in the amount of fixed costs occurs in the process of increasing sales volume, the company needs to overcome the new break-even point or adapt its production activities to it. In other words, after such a jump, the effect of production leverage manifests itself in new economic conditions in a new way.
Understanding the mechanism of manifestation of production leverage allows us to purposefully manage the ratio of fixed and variable costs in order to increase the efficiency of production and economic activities under various trends in the commodity market conditions and the stage of the enterprise’s life cycle.
In case of unfavorable conditions on the product market, which determines a possible decrease in sales volume, as well as in the early stages of the enterprise’s life cycle, when it has not yet overcome the break-even point, it is necessary to take measures to reduce the enterprise’s fixed costs. And vice versa, with favorable conditions on the commodity market and the presence of a certain margin of safety, the requirements for implementing the regime for saving fixed costs can be significantly weakened. During such periods, an enterprise can significantly expand the volume of real investments by reconstructing and modernizing fixed production assets.
When managing fixed costs, it should be borne in mind that their high level is largely determined by industry characteristics of activity, which determine different levels of capital intensity of manufactured products, differentiation of the level of mechanization and automation of labor. In addition, it should be noted that fixed costs are less amenable to rapid change, so enterprises with high production leverage lose flexibility in managing their costs.
Each enterprise has sufficient opportunities to reduce (if necessary) the amount and share of fixed costs. Such reserves include: a significant reduction in overhead costs (management costs) in the event of unfavorable commodity market conditions; sale of part of unused equipment and intangible assets in order to reduce the flow of depreciation charges; widespread use of short-term forms of leasing of machinery and equipment instead of purchasing them as property; reduction in the volume of a number of consumed utilities.
When managing variable costs, the main guideline should be to ensure constant savings, because There is a direct relationship between the sum of these costs and the volume of production and sales. Providing these savings before the enterprise overcomes the break-even point leads to an increase in marginal income, which allows it to quickly overcome this point. After overcoming the break-even point, the amount of savings in variable costs will provide a direct increase in the profit of the enterprise. The main reserves for saving variable costs include reducing the number of workers in main and auxiliary production by ensuring an increase in their labor productivity; reducing the size of stocks of raw materials, supplies and finished products during periods of unfavorable commodity market conditions; ensuring favorable conditions for the supply of raw materials and materials for the enterprise.
Using the mechanism of production leverage, targeted management of fixed and variable costs, and promptly changing their ratio under changing business conditions will increase the profit-generating potential of the enterprise.
For domestic enterprises, the method of analyzing the break-even of production is not yet officially recommended, and therefore for now it is used mainly for forecast calculations of prices, profits, and sales revenue. Manufacturers working in a real market economy can appreciate the analytical capabilities of this method.
Conclusion
When writing this course work, the basic concepts of leverage, its tasks, functions were described, and its use in enterprises in market economy. Let's briefly describe the main thing:
Leverage is a complex system for managing assets and liabilities of an enterprise. Any enterprise strives to achieve two main goals of its activities, i.e.:
♦ increasing profits;
♦ increasing the value of the enterprise itself.
Under these conditions, leverage becomes the very tool that allows you to achieve these goals by influencing changes in the ratios and profitability of equity and debt capital.
Leverage is divided into three main types:
♦ financial;
♦ operational;
♦ financial and operational.
Depending on the tasks set at the enterprise, aimed at improving the financial position of the enterprise, one or another type of leverage is used.
When performing this course work, the following conclusions were made, certain shortcomings were identified and the following recommendations were proposed.
An enterprise can partially attract borrowed capital with a fixed return on assets and thereby increase the return on equity capital through the most rational use of its own funds (capital). But financial leverage also has significant disadvantages, since there are financial (leverage) risks that can make an enterprise dependent on borrowed funds (credits, loans, borrowings) in the event of insufficient funds to pay off loans.
In this case, the enterprise experiences a loss of liquidity or financial stability, which can gradually lead to bankruptcy of the enterprise, but this happens quite rarely, and most often due to an incorrect management structure of the enterprise and finances in general.
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