Page 168 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 7: Concept of Leverages

Case I: A 50% increase in sales (from 2000 to 3000 units) results in a 100% increase in EBIT (from Notes
50,000 to 100,000).
Case II: A 50% decrease in sales (from 2000 to 1000 units) results in a 100% decrease in EBIT (from
50,000 to zero).

Hence Operating leverage =

= = 2 (case I), = 2 (case II).

Self Assessment

Fill in the blanks:
1. Operating leverage results from the existence of the fixed operating expenses in the firm’s
………………… stream.
2. ………………… costs are those which do not vary with sales volume.
3. ………………… costs are those, which are partly fixed and partly variable.

4. ………………… costs are the costs which vary directly.
7.2 Relation with Break-even Analysis

Break-even analysis is used by the firm.
1. To determine the level of operations necessary to cost all operating costs and,
2. To evaluate the profitability associated with various levels of sales. The firms operating
break-even point are the level of sale necessary to give all operating costs. At that point,
earnings before interest and taxes equal zero.

In the example, we see that the firm has reached break-even (‘0’ profit) at the sales level of 1000
units, at which all the fixed and variable operating costs are coursed.

Did u know? Break-even analysis is sometimes called cost volume profit analysis.

7.2.1 Changing Costs and the Operating Break-even Point

The firm’s operating break-even point is sensitive to a number of variables. Fixed operating
cost, the sales price per unit and the variable cost per unit. The effects of increase or decrease in
these variables can be analyzed as under:

Increase in variable Effect on operating break-even
Fixed operating costs Increase
Sales price per unit Decrease

Variable operating cost per unit Increase

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