Production leverage.

The relationship between profit and the valuation of the costs of assets or funds incurred to obtain this profit is characterized by the indicator “leverage” (lever). This is a certain factor, a small change in which can lead to a significant change in a number of performance indicators.

Production (operational) leverage is quantitatively characterized by the ratio between fixed and variable costs in their total amount and the variability of the indicator “earnings before taxes”. It is this indicator of profit that allows us to identify and evaluate the impact of operating leverage on the financial results of the company.

The level of production leverage is calculated by the formula:


where FС – fixed costs in monetary units;

VC – total variable costs in monetary units.

, where

z – specific variable costs per unit of production;

Q is the sales volume in real terms.

The concept of operating leverage is related to the effect of operating leverage. It is due to the fact that any change in revenue from product sales leads to a greater change in profit, obtained due to the stabilization of fixed costs for the entire volume of production.

The effect of production leverage is calculated by the formula:

, where

P – profit of the enterprise for the reporting period;

, where

R is the company’s revenue for the period;

, where

P is the selling price of a unit of production;

Cont is the value of the contribution;

If the share of fixed costs is high, the company is said to have a high level of operating leverage. For such a company, even a slight change in production volumes can lead to a significant change in profits, since the company has to bear fixed costs in any case, whether products are produced or not. Thus, the variability in earnings before interest and taxes due to changes in operating leverage quantifies production risk. The higher the level of operating leverage, the higher the company’s production risk.

However, it cannot be considered that a high share of fixed costs in the cost structure of an enterprise is a negative factor. An increase in production leverage may indicate an increase in the production capacity of an enterprise, technical re-equipment, an increase in labor productivity, as well as the implementation of research and development projects. All these factors, which are undoubtedly positive, are manifested in an increase in fixed costs and lead to an increase in the effect of production leverage.

The effect of production leverage is manifested in the fact that with an increase in the company’s revenue, profit also changes, and the higher the level of production leverage, the stronger this effect,

An analysis of the fixed and variable costs of an enterprise makes it possible to identify the level of risk, which is a necessary stage in planning and making managerial decisions.

So, the level of production leverage that has developed in the company is a characteristic of the potential opportunity to influence profit before interest and taxes by changing the cost structure and output volume.

Financial leverage

Quantitatively, this characteristic is measured by the ratio between borrowed and own capital; the level of financial leverage directly proportionally affects the degree of financial risk of the company and the rate of return required by shareholders. The higher the amount of interest payable, which, by the way, is a permanent obligatory expense, the lower the net profit. Thus, the higher the level of financial leverage, the higher the financial risk of the company.

The level of financial leverage of a company is calculated by the formula:


where ZK – borrowed capital;

SC – equity.

A heavily leveraged company is called a highly leveraged company, or financially dependent company ; a company that finances its activities only from its own funds is called financially independent .

The costs of servicing loans are fixed, since they are obligatory for the enterprise to pay, regardless of the level of production and sales of products. It is obvious that if the market situation develops unsuccessfully and the company’s revenue turns out to be low, then an enterprise with a higher level of financial leverage (and, accordingly, with high financial costs) will lose financial stability much earlier and become unprofitable than an enterprise that preferred to finance its activities from its own resources. sources and thus kept a low level of financial dependence on external creditors. Therefore, a high level of financial leverage is a reflection of the high risk inherent in this enterprise.

So, the level of financial leverage that has developed in the company is a characteristic of the potential opportunity to influence the net profit of a commercial organization by changing the volume and structure of long-term liabilities.

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