Break Even Analysis_ Bestone

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Copyright, 2008, JaxWorks, All Rights Reserved.

This workbook was produced at the request of hundreds of our loyal visitors togreat demand for an in-depth understanding of the financial "tool-of-tools" knoActually the Break-Even is only a portion of a larger concept known as "Contrhas at its heart the analysis of cost/volume/and profit relationships.

This product makes an attempt at demystifying all of these concepts with eThis workbook can be used with your business by entering your own data.

NeoCalc Comprehensive Break-Eve


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our web site. It appears there is an as the Break-Even Analysis.

ibution and Margin Analysis" that

amples and popup explanations.

Analysis


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JaxWorks Break-Even Analysis

Calculating The Contribution Margin - Figure 1

Sales (1000 CDs @ $10) $10,000

Less: Costs associated with production:

Employee costs (1000 CDs @ $0.50): $500

Materials costs (1000 CDs @ $5): $5,000

Packaging costs (1000 CDs @ $1): $1,000

Total variable costs: $6,500

Contribution margin: $3,500

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Contribution Margin Analysis - Figure 2

CDs Sold: 4510 Employee cost calculationCDsMade UnitCost

Sales @ $10 per CD $45,100.00 0 $0.50

1000 $0.60

Less: Variable costs of production: 2000 $0.70

3000 $0.80

Employee costs (semi-variable): $3,059.00 4000 $0.90

5000 $1.00

Materials costs (variable) $22,550.00

MaterialsCost: $5.00

Packaging costs (variable) $4,510.00

PackagingCost: $1.00

Total variable costs: $30,119.00

Contribution margin: $14,981.00

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Per Unit and Percent of Sales Contribution Analysi

Employee cost CDs Sold 4510per quantity Total

$500.00 Sales (CDs @ $10 each) $45,100.00

$600.00

$700.00 Less:

$800.00 Labor (CDs at semi-variable per CD) $3,059.00

$459.00 Materials (CDs at $5 per CD) $22,550.00

$0.00 Packaging costs @ $1 per CD $4,510.00

Contribution Margin $14,981.00

CDs Sold 5510

Total

Sales (CDs @ $10 each) $55,100.00

Less:

Labor (CDs at semi-variable per CD) $4,010.00

Materials (CDs at $5 per CD) $27,550.00

Packaging costs @ $1 per CD $5,510.00

Contribution Margin $18,030.00

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s - Figure 3 Operating Income Statemen

Total Per unitPer Unit % of Margin Sales $2,000 $20

$10.00 100.00% Less:

Materials $400 $4

Labor $900 $9

$0.68 6.78% Variable Overhead $300 $3

$5.00 50.00% Contribution margin: $400 $4

$1.00 10.00%

$3.32 33.22% Quantity Sold or Produced 100

Per Unit % of Margin

$10.00 100.00%

$0.73 7.28%

$5.00 50.00%

$1.00 10.00%

$3.27 32.72%

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- Figure 4 E

Percent of margin100% Sales

Less:

20% Material

45% Labor

15% Variable Overhead

20% Contribution margin:

Quantity Sold or Produced

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xcel Formulas for Operating Income Statement - Figure 5

Total Per unit Percent of marginAN16*AO8 $20 100%

$AN$16*AO10 $4 AO10/$AO$8

$AN$16*AO11 $9 AO11/$AO$8

$AN$16*AO12 $3 AO12/$AO$8

AN8-SUM(AN10:AN12) AO8-SUM(AO10:AO12) AO13/$AO$8

100

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Using Goal Seeker to Find Break-Even - Figure 6

Fixed costs Sales price Variable cost Break-Even units50 20 15 10

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Fixed Costs - Figure 7

Volume (units) Fixed Costs1 $50

2 $50

3 $50

4 $50

5 $50

6 $50

7 $50

8 $50

9 $50

10 $50

$0

$10

$20

$30

$40

$50

$60

1 2 3 4 5 6 7 8 9

Costs

Volume (units)

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Volume (units) Variable Costs1 $15

2 $30

3 $45

4 $60

5 $75

6 $90

7 $105

8 $120

9 $135

10 $150

Fixed Costs

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Variable Costs - Figure 8

$0

$20

$40

$60

$80

$100

$120

$140

$160

1 2 3 4 5 6 7 8 9 10

Costs

Volume (units)

Variable Costs

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The Classic Break-Even Point Chart - Figure 9

Volume Fixed Variable Total Total(units) Costs Costs Costs Sales

1 $50 $15 $65 $20

2 $50 $30 $80 $40

3 $50 $45 $95 $60

4 $50 $60 $110 $80

5 $50 $75 $125 $100

6 $50 $90 $140 $120

7 $50 $105 $155 $140

8 $50 $120 $170 $160

9 $50 $135 $185 $180

10 $50 $150 $200 $200

11 $50 $165 $215 $220

12 $50 $180 $230 $240

13 $50 $195 $245 $260

14 $50 $210 $260 $280

15 $50 $225 $275 $300

16 $50 $240 $290 $320

17 $50 $255 $305 $340

18 $50 $270 $320 $360

19 $50 $285 $335 $380

$0

$50

$100

$150

$200

$250

$300

$350

$400

Costs

Volume (units)

Fixed Costs Total Costs

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

1 3 5 7 9 11 13

Volume (units)

Costs

Fixed Cost s T otal Costs T

The graphical representation of a company'scurrent cost/volume/profit relationship gives youan effective tool for determining what adjustmentsyou need to make to volume, cost, or both so asto increase your profit level. Relationships amongthese variables can become extremely complex,especially when several different products areinvolved.

When you are dealing with a complicatedsituation, it is usually easier to make sense of therelationships by viewing them on a chart, ratherthan by gazing at a table of raw numbers.

Loss

Break-Even

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Non-linear Revenue Growth From

Sales Price per Unit = $20Volume (units) Discount Revenue

5 0.0% $100

10 2.5% $195

15 5.0% $285

20 7.5% $370

25 10.0% $450

30 12.5% $525

35 15.0% $595

40 17.5% $660

45 20.0% $720

50 22.5% $775

55 25.0% $825

60 27.5% $870

65 30.0% $910

70 32.5% $945

75 35.0% $975

80 37.5% $1,000

85 40.0% $1,020

90 42.5% $1,035Total Sales

$

$

$

$

$1,

$1,

Revenue

15 17 19

otal Sales

Profit

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iving Discounts - Figure 10 Non

Sales Price per Unit =Volume

(units)

5

10

15

20

25

30

35

40

45

50

55

60

65

70

75

80

85

90

$0

200

400

600

800

000

200

Volume (units)

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-linear Increases In The Contribution Margin From Purchase Discounts - Figure 11

$20Supplier Variable Sales Contribution

Discount Costs margin

0.0% $75 $100 $25

2.5% $146 $200 $54

5.0% $214 $300 $86

7.5% $278 $400 $123

10.0% $338 $500 $163

12.5% $394 $600 $206

15.0% $446 $700 $254

17.5% $495 $800 $305

20.0% $540 $900 $360

22.5% $581 $1,000 $419

25.0% $619 $1,100 $481

27.5% $653 $1,200 $548

30.0% $683 $1,300 $618

32.5% $709 $1,400 $691

35.0% $731 $1,500 $769

37.5% $750 $1,600 $850

40.0% $765 $1,700 $935

42.5% $776 $1,800 $1,024

$0

$200

$400

$600

$800

$1,000

$1,200

ContributionMargin

Volume (units)

Contribution margin

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Sales Mix Analysis - Figure 12

Fixed costs = $34,000

8-oz. Per 6-oz. Per 4-oz.

Package size Unit Unit

Sales (units) 10,000 15,000 20,000

Sales (dollars) $74,000 $7.40 $94,050 $6.27 $102,600

Less variable costs $37,500 $3.75 $50,850 $3.39 $60,600

(as % of Sales) 51% 54% 59%

Contribution margin $36,500 $3.65 $43,200 $2.88 $42,000

(as % of Sales) 49% 46% 41%

Sales mix 27% 35% 38%

Break-Even $68,932 $74,021 $83,057

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Redistribution of Sales Mix To Incre

Fixed costs = $34,000

Per 8-oz. Per 6-oz.

Unit Total Package size Unit

Sales (units) 15,000 20,000

$5.13 $270,650 Sales (dollars) $111,000 $7.40 $125,400

$3.03 $148,950 Less variable costs $56,250 $3.75 $67,800

55% (as % of Sales) 51% 54%

$2.10 $121,700 Contribution margin $54,750 $3.65 $57,600

45% (as % of Sales) 49% 46%

100% Sales mix 42% 48%

$75,613 Break-Even $68,932 $74,021

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se Profits - Figure 13 Ana

Per 4-oz. Per

Unit Unit Total Sales

5,000

$6.27 $25,650 $5.13 $262,050 Less variable costs

$3.39 $15,150 $3.03 $139,200 Contribution margin

59% 53%

Less direct fixed costs

$2.88 $10,500 $2.10 $122,850

41% 47% Segment margin

10% 100%

$83,057 $72,525

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lyzing Segment Margin - Figure 14

Household Ceramic CeramicCeramics Tiles Conductors

$1,100 $3,500 $5,000

$690 $2,000 $3,750

$410 $1,500 $1,250

$200 $1,000 $1,000

$210 $500 $250

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Break-Even Analysis

Chart Presentation

$0

$50

$100

$150

$200

$250

$300

$350

$400

Costs

Volume (units)

Fixed Costs Total Costs Total Sales

Copyright, 2001, Jaxworks, All Rights Reserved.


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Year 1 Year 2 Current BE Chart Projected BE ChartSales $ 195$ 839$ Sales $ 195$ Sales $ 839$

Fixed $ 133$ 262$ Fixed $ 133$ Fixed $ 262$

Total Variable $ $71 $363 Total Variable $ $71 Total Variable $ $363

Total Variable % 36.41% 43.27%

Profit $ (9)$ $214

Break-Even % 107.26% 55.04%

BE Dollars 209$ 462$

BE Date Jan 25 Jul 18

THE B/E POINT IS IN NEXT YEARBECAUSE PROFIT IS NEGATIVE.

Click Here For Large View Click Here For Large View

Current Pie Projected Pie

Fixed % 68.21% Fixed % 31.23%

Total Variable % 36.41% Total Variable % 43.27%

Profit % (4.62%) Profit % 25.51%

Click Here For Large View Click Here For Large View

$0

$50

$100

$150

$200

$250

Jan

Mar

May

Jul

Sep

Nov

Months

Current Break-Even Chart Analysis

BREAK-EVEN ANALYSISEnter figures in cells with Blue numbers and White Background only.

This worksheet is designed to perform what-if analysis in the projected cells. After entering yourcurrent data, you can experiment by reducing Variable and/or Fixed Expenses or increasing Sales.

You will find it is much easier to reduce expenses than increase Sales. Scroll Down for Pie Charts.

Fixed % Total Variable % Profit % Fixed % Total Variable % Profit %

$0

$100

$200

$300

$400

$500

$600

$700

$800

$900

Jan

Mar

May

Jul

Sep

Nov

Months

Projected Break-Even Chart Analysis



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Return To Data Entry

$0

$50

$100

$150

$200

$250

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Months

Current Break-Even Chart Analysis


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Return To Data Entry

$0

$100

$200

$300

$400

$500

$600

$700

$800

$900

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Break-Even Chart Analysis

REVENUE FIXED COSTS TOTAL COSTS


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Break-Even Chart Analysis

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Months

Fixed Costs

Total Costs

Revenue

Profit

Loss

Break-Even Point


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Current Pie

68.21%

36.41%

(4.62%)

Fixed % Total Variable % Profit %


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Projected Pie

31.23%

43.27%

25.51%

Fixed % Total Variable % Profit %


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Planning For ProfitApplying Break-Even Tools

The concepts ofoperat ing lev erage and f inanc ial lev erage are key to an accurate analysis of a companys vfirm is leveraged whenever it incurs either fixed operating costs (operating leverage) or fixed capital costs (fi

leverage). More specifically, a firms degree of operating leverage is the extent to which its operations involvoperating expenses such as fixed manufacturing costs, fixed selling costs, and fixed administrative costs.

A firms degree of financial leverage is the extent to which that firm finances its assets by borrowing. More specifinancial leverage is the extent to which a firms Return on Assets exceeds the cost of financing those assmeans of debt. The firm expects that the leverage acquired by borrowing will bring it earnings that will excefixed costs of the assets and of the sources of funds. The firm expects that these added earnings will increaamount of returns to shareholders.

T o d ay i t i s a lm o s t i m p o s s i b le f o r a f i r m t o s u c c e e d f i n a n c ia ll y w i t h o u t u s i n g s o m e f o r m o f l e v e r ag e . commonly use leverage as a tool to help bolster their financial position and operating condition (for examplreturn to stockholders).

However, with increased leverage comes increased risk. If your company chooses to be highly leveraged, itwilling to accept the risk that the downside losses will be as great as its upside profits. This can easily occur ifsales volume is not large enough to cover its fixed operating expenses and the required interest payments on it

You can find plenty of examples of this phenomenon in a stack of annual reports from the 1980s. Within thayou can find several companies that were highly leveraged. Tracking these firms through the 1990s, you woutrends depicting peaks and troughs: the positive and the negative impacts of using leverage to operate a buMany firms were acquired via "Leveraged buyouts," where the funds needed to make the acquisition were them

borrowed (hence the term "leveraged").

The likelihood of experiencing these kinds of swings is one reason that managers, analysts, and stockholderapply the concepts of operating and financial leverage to accurately analyze a firms overall value and financial

An additional concept that is useful in interpreting the risks due to operating leverage and financial leverbusiness risk. Business risk is the inherent uncertainty of doing business. It represents the risk that a coassumes by the nature of the products it manufactures and sells, its position in the marketplace, itsstructurein short, all the fundamental aspects involved in the creation of profitable revenues. Assuming adegree of operating or financial leverage is seldom risky when the business risk is very low. But if the busineitself is high, then increasing the degree of either type of leverage compounds the risk.

Analyzing Operating Leverage


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Fixed design and layout per box = $3.00 Total cost per box: $18.00

On the other hand, purchasing a computer and a modem will cost $1,400. This will introduce a new, fixed costproduction of the cards. You will have to sell 70 boxes of greeting cards (70 boxes * $20.00 profit) to cover thethe equipmentthat is, to break even on the investment.

Case Study: Greeting Cards

Operating leverage is the extent to which a firms operations involve fixed operating expenses. Managers canthe degree of operating leverage they want the firm to incur, based on the choices they make regardinexpenses. They can, for example, acquire new equipment that increases automation and reduces variablexpenses. Alternatively, they can choose to maintain their variable labor expenses. Other things being equmore automated equipment a firm acquires through capital investment, the higher its operating leverage will be.

You own a small company that prints customized greeting cards. At present, your variable operating costs areper card to print a box of 500 cards, which you sell for $35.00.

One of your employees suggests that, if you purchase a personal computer and a modem, your customers coultheir own designs for greeting cards to you electronically. This would save you the cost of doing the design andof the cards for each order.

Operating income per box: $17.00

If you can remove the cost of design and layout, your total costs will drop from $18.00 to $15.00 per order anoperating income per box will increase from $17.00 to $20.00.

You review some recent orders and find that you paid an employee an average of $3.00 per order to do theand layout. So your costs and profit per order are as follows:

Variable $0.03 per card for 500 cards = $15.00


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Store A

Fixed costs: $20,000.00 Variable costs: $1.50 Unit price: $2.00

Units Sold (000) Sales Fixed costs Variable Costs Total Costs Profits

20 $40,000 $20,000 $30,000 $50,000 ($10,000)

50 $100,000 $20,000 $75,000 $95,000 $5,000

80 $160,000 $20,000 $120,000 $140,000 $20,000

110 $220,000 $20,000 $165,000 $185,000 $35,000

140 $280,000 $20,000 $210,000 $230,000 $50,000

170 $340,000 $20,000 $255,000 $275,000 $65,000

200 $400,000 $20,000 $300,000 $320,000 $80,000

Case Study: Comparing the Degree of Operating LeverageFor a more detailed example, consider three different specialty stores whose operations are identical in all reexcept for the decisions they have made regarding their variable and fixed expenses:

Store A has decided to incur the lowest fixed and highest variable costs of the three stores. It has little in thespecial equipment, and relies heavily on the experience and knowledge of its salespeople. At this store,commissions are relatively high.

Now suppose that your business card orders are not so dependable. Most of your business depends on the patrof one large account. When its business is good, and it is hiring and promoting staff, you receive frequent ordeit for greeting cards. But when its business is not so good, you can go for several months with only a few orders.

If the timing of your investment in the computer coincides with a drop in orders for greeting cards, the computesit idle for several months. There will be little profit to cover its cost, the break-even point will be pushed well ifuture, and you will have lost the opportunity to invest the $1,400 in some other manner, such as advertisinleverage is actually working against you.

Of course, there are other considerations you must take into account. You would want to consider how many

customers have the inclination and equipment to send their own designs to you, whether they would demandbreak if they do so, maintenance on the computer, and so on. Business decisions are seldom clear-cut.

So, operating leverage cuts both ways. A good decision can increase your profitability dramatically, once yobroken even on the fixed cost. Bad timing can cut your profitability dramatically if it takes longer than anticipbreak even on the investment.

You should base your decision on how dependable your business card orders are. Suppose that you have astream of around 60 orders per month. In that case, you break even on the investment in a little over a montafter that you show an additional $3.00 profit for every order. That added profit is the result of leveraging yourinvestment.

$250,000

$300,000

$350,000

$400,000

$450,000

lesandProfit

Store A


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Store B has decided to incur fixed costs that are higher than that of Store A, but to keep its variable costs lowStore A. This store has invested a moderate amount of money in paint-mixing equipment that enables a salesto match paint samples automatically. It believes that reliance on this equipment allows it to hire salespeople wless experienced; its sales staff therefore does not earn as much as that at Store A.

$0

$50,000

$100,000

$150,000

,

20 50 80 110 140 170 200

Cost,Sa

Units Sold (000)


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Store BFixed costs: $40,000.00 Variable costs: $1.20 Unit price: $2.00


20 $40,000 $40,000 $24,000 $64,000 ($24,000)

50 $100,000 $40,000 $60,000 $100,000 $0

80 $160,000 $40,000 $96,000 $136,000 $24,000

110 $220,000 $40,000 $132,000 $172,000 $48,000

140 $280,000 $40,000 $168,000 $208,000 $72,000

170 $340,000 $40,000 $204,000 $244,000 $96,000

200 $400,000 $40,000 $240,000 $280,000 $120,000

Store CFixed costs: $60,000.00 Variable costs: $1.00 Unit price: $2.00


20 $40,000 $60,000 $20,000 $80,000 ($40,000)

50 $100,000 $60,000 $50,000 $110,000 ($10,000)

80 $160,000 $60,000 $80,000 $140,000 $20,000

110 $220,000 $60,000 $110,000 $170,000 $50,000

140 $280,000 $60,000 $140,000 $200,000 $80,000

170 $340,000 $60,000 $170,000 $230,000 $110,000

200 $400,000 $60,000 $200,000 $260,000 $140,000

Store C has decided to incur the highest fixed and lowest variable costs of the three. It has invested heequipment that not only matches paint samples exactly, but mixes paints automatically to produce a galmatching paint. Its salespeople need no special knowledge, and receive lower commissions than the sales stStore A and Store B.

The examples above display an analysis of each stores sales and Earnings Before Interest and Taxes (EBITgiven quantity of sales at their existing fixed costs, variable costs, and unit sales rates.

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

$400,000

$450,000

20 50 80 110 140 170 200

Cost,SalesandProfit

Units Sold (000)

Store B

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

$400,000

$450,000

20 50 80 110 140 170 200

Cost,SalesandProfit

Units Sold (000)

Store C


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The examples also make some trends evident. These trends are consequences of each stores decision asrelationship between its variable costs and its fixed costs:


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Store A Store B Store C

Fixed costs: $20,000 $40,000 $60,000

Variable costs: $1.50 $1.20 $1.00

Sales price: $2.00 $2.00 $2.00

Store A

Units Sold (000) Sales Fixed costs Variable Costs Profits

20 $40,000 $20,000 $30,000 ($10,000)

50 $100,000 $20,000 $75,000 $5,000

80 $160,000 $20,000 $120,000 $20,000

110 $220,000 $20,000 $165,000 $35,000

140 $280,000 $20,000 $210,000 $50,000

170 $340,000 $20,000 $255,000 $65,000

200 $400,000 $20,000 $300,000 $80,000

Store B

20 $40,000 $40,000 $24,000 ($24,000)

50 $100,000 $40,000 $60,000 $0

80 $160,000 $40,000 $96,000 $24,000

110 $220,000 $40,000 $132,000 $48,000

140 $280,000 $40,000 $168,000 $72,000

170 $340,000 $40,000 $204,000 $96,000

200 $400,000 $40,000 $240,000 $120,000

Store C

20 $40,000 $60,000 $20,000 ($40,000)

50 $100,000 $60,000 $50,000 ($10,000)

80 $160,000 $60,000 $80,000 $20,000

110 $220,000 $60,000 $110,000 $50,000

140 $280,000 $60,000 $140,000 $80,000

170 $340,000 $60,000 $170,000 $110,000

200 $400,000 $60,000 $200,000 $140,000

Store B, which has fixed costs that fall between Store A and Store B, breaks even slower than Store A but fastStore C. Once it reaches its break-even point, it is more profitable than Store A because its unit sales cost ithan Store A. However, after breaking even on its paint-matching equipment, Store B is less profitable, in teEBIT, than Store C as sales increase: it pays its sales staff a higher commission than does Store C.

Store C, which has the highest fixed costs and the lowest per unit sales cost, breaks even more slowly than thtwo stores. But after the break-even point has been reached, Store Cs EBIT rises faster than either Store A oB because of its low sales commission rates.

Store A, which has the lowest fixed cost and the highest per unit cost, will break even faster than Store B and SHowever, once the break-even point has been met and as the level of production increases, Store As EBIT willas great as either Store Bs or Store Cs. This is because Store A has the highest per unit sales cost. No mattmany gallons of paint it sells, it incurs the same, relatively high sales commission on each sale.

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

$160,000

rofits($)


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($60,000)

($40,000)

($20,000)

$0

20,000

20 50 80 110 140 170 200

Units Sold (000)



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Fixed costs: $20,000 $40,000 $60,000

Variable costs: $1.50 $1.20 $1.00

Sales price: $2.00 $2.00 $2.00

Units Sold

000 Sales Fixed costs Variable costs EBIT DOL

Store A 120 $240,000 $20,000 $180,000 $40,000 1.50

Store A 200 $400,000 $20,000 $300,000 $80,000 1.25

Store B 120 $240,000 $40,000 $144,000 $56,000 1.71

Store B 200 $400,000 $40,000 $240,000 $120,000 1.33

Store C 120 $240,000 $60,000 $120,000 $60,000 2.00

Store C 200 $400,000 $60,000 $200,000 $140,000 1.43

Each store sells the same number of units: 120,000 or 200,000. Each store sells them for the same price: $2.

unit. But because the stores differ in their fixed and variable costs, they also differ in their 1 BIT. For Store A,increase in unit sales from 120,000 to 200,000 results in a (67% * 1.5 DOL) or 100% increase in EBIT. For Sto67% increase in unit sales results in a (67% * 1.7 DOL) or 114% increase in EBIT. And Store C experiences a2.0 DOL) or 133% increase in EBIT. So, the higher the DOL, the greater the EBIT as unit sales increase.

Expressed in raw dollar amounts, an increase in unit sales from 120,000 to 200,000 means an increase in pr$40,000 for Store A, $64,000 for Store B, and $80,000 for Store C.

Store A, for example, has a DOL of 1.5 with unit sales of 120,000:DOL =120,000*($2.00-$1.50)/(120,000*($2.00-$1.50)=$20,000)DOL = 1.5

These calculations quantify the data shown in example below. The numbers indicate that the EBIT of the comthat have the greatest operating leverage are also the most sensitive to changes in sales volume.

or, equivalently:

Degree of Operating Leverage (DOL)

DOL = Contribution Margin/(Contribution Margin Fixed Cost)Using the data for the three specialty stores, one can calculate the DOL at the point where unit sales are 120,00

Another way to understand how operating leverage impacts yourcompanys profitability is by calculating theof Operating Leverage (DOL):

DOL = Units*(Price-Variable Cost)/(Units*(Price-Variable Cost)-Fixed Cost)

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

$160,000

120 200 120 200 120 200

Store A Store A Store B Store B Store C Store C

Profit($)

Units Sold (000)


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Fixed costs: $20,000 $40,000 $60,000

Variable costs: $1.50 $1.20 $1.00

Sales price: $2.00 $2.00 $2.00

Units Sold

(000) Sales Fixed costs Variable costs EBIT DOL

Store A 200 $400,000 $20,000 $300,000 $80,000 1.25

Store A 120 $240,000 $20,000 $180,000 $40,000 1.50

Store B 200 $400,000 $40,000 $240,000 $120,000 1.33

Store B 120 $240,000 $40,000 $144,000 $56,000 1.71

Store C 200 $400,000 $60,000 $200,000 $140,000 1.43

Store C 120 $240,000 $60,000 $120,000 $60,000 2.00

Case Study: Hot-dog SalesHotDog Man is a small business that sells specialty coffee drinks at office buildings. Each morning and aftetrucks arrive at offices front entrances, and the office employees purchase hotdogs and drinks. The businprofitable, but HotDog Mans offices are located to the north of town, where rents are less expensive, and the prsales area is south of town. This means that the trucks must drive crosstown four times each day.

The cost of transportation to and from the sales area, plus the power demands of the trucks coffee bequipment, are significant portions of the variable costs. HotDog Man could reduce the amount of drivingtherefore, the variable costsif it moves the offices much closer to the sales area.

However, the calculated DOL will be the same on the downside. So for every decrease in sales volume, eachDOL will cause an unwanted decrease in EBIT corresponding to the desired increase in EBIT (see example bel

The DOL gives managers a great deal of information for setting operating targets and planning profitabiliexample, you would want to make operating leverage decisions based on your knowledge of how your salesfluctuates. If your company experiences large swings in sales volume throughout the year, it would be much rimaintain a high degree of leverage than it would be if your company has a predictable, steady stream of sales.

$0$20,000$40,000$60,000

$80,000$100,000$120,000$140,000$160,000

200 120 200 120 200 120

Store A Store A Store B Store B Store C Store C

Profit($)

Units Sold (000)


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Units sold per month 20,000 Unit variable costs $0.60

Average unit sales price $2.20 Current fixed costs $10,000

Contr ibution margin $202,986

DOL 2.45

Fixed Variable

1994 sales month Units Sales costs Costs EBIT

January 6,582 $14,480 $10,000 $3,949 $531

February 11,121 $24,466 $10,000 $6,673 $7,794

March 14,178 $31,192 $10,000 $8,507 $12,685

April 13,692 $30,122 $10,000 $8,215 $11,907

May 11,597 $25,513 $10,000 $6,958 $8,555

June 9,599 $21,118 $10,000 $5,759 $5,358

July 9,913 $21,809 $10,000 $5,948 $5,861

August 10,926 $24,037 $10,000 $6,556 $7,482

September 14,349 $31,568 $10,000 $8,609 $12,958October 12,965 $28,523 $10,000 $7,779 $10,744

November 6,972 $15,338 $10,000 $4,183 $1,155

December 4,972 $10,938 $10,000 $2,983 ($2,045)

Sum: $82,986

Standard Deviation: $4,963

Units sold per month 20,000 Unit variable costs $0.35

Average unit sales price $2.20 Current fixed costs $10,000

Additional monthly lease Contribution margin $234,702

payment, new offices: $2,200 DOL 2.66

Projected fixed costs: $12,200

Fixed Variable

1994 sales month Units Sales costs Costs EBIT

January 6,582 $14,480 $12,200 $2,304 ($23.30)

February 11,121 $24,466 $12,200 $3,892 $8,374

March 14,178 $31,192 $12,200 $4,962 $14,029

April 13,692 $30,122 $12,200 $4,792 $13,130

May 11,597 $25,513 $12,200 $4,059 $9,254

June 9,599 $21,118 $12,200 $3,360 $5,558

July 9,913 $21,809 $12,200 $3,470 $6,139

August 10,926 $24,037 $12,200 $3,824 $8,013

September 14,349 $31,568 $12,200 $5,022 $14,346

October 12,965 $28,523 $12,200 $4,538 $11,785

November 6,972 $15,338 $12,200 $2,440 $698

December 4,972 $10,938 $12,200 $1,740 ($3,002)

Sum: $88,302

Standard Deviation: $5,738

Although the lease of new offices would increase the fixed costs, a careful estimate of the potential savigasoline and vehicle maintenance indicates that HotDog Man could reduce the variable costs from $0.60 per$0.35 per unit. Total sales are unlikely to increase as a result of the move, but the savings in variable costsincrease the annual profit from $82,986 to $88,302. This is a 6.4% growth in profit margin: not an insignificant a(see below).

HotDog Man presently has fixed costs of $10,000 per month. The lease of a new office, closer to the salewould cost an additional $2,200 per month. This would increase the fixed costs to $12,200 per month (see belo


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Unit Unit Total Fixed Unit Total Net Increase

Sales Price Sales Costs variable variable operating in net

costs costs income income

In January, for example, the managers of Firms A, B, and C might set out their annual operations and profit tarmeans of the following assumptions:

We want to increase our sales volume from 120,000 to 200,000. Our market research leads us to believe that to sell an additional 80,000 units we must lower our unit salefrom $2.00 to $1.70.

Neither total fixed costs nor unit variable costs will change during this year.

Variability in profit levels, whether measured as EBIT, operating income, or net income does not necessarily inthe level of business risk as the DOL increases. If the variability is predictableif the timing and size of thecan be forecast with confidencethen a company can anticipate and allow for them in its budgets.

Planning by Using the DOL

Based on these assumptions, the change in net operating income for each firm would be as shown below.

The increase in variability is also reflected in the HotDog Mans DOL. As shown in both examples, the DOLincrease from 2.45 to 2.66 as a result of increasing fixed costs and decreasing variable costs. Both the DOL a

business risk would increase if HotDog Man moved its offices.

If HotDog Man has plenty of money in the bank to meet unexpected expenses, such as major repairs to its trthe trucks coffee brewers, then the acceptance of greater fixed costs may make good financial as well as opersense.

But if HotDog Mans owners frequently take profits out of the business, so that it has relatively little in theresources to cushion the impact of unexpected expenses, it might be unwise to add to its fixed costs. Wheremoney come from to repair a truck that breaks down at the end of January?

Managers can use the DOL to plan not only their operations, as was done in the HotDog Man case study, b

their net income and their pricing. It is useful to perform sensitivity analysis around sales volume levels, andadjustments to both fixed and variable expenses.

But look at the change in the variability of the profit from month to month. From November through January, whmuch more difficult to lure office workers out into the cold to purchase coffee, HotDog Man barely breaks efact, in December of 1994, the business lost money.

The example above indicates that by moving some of the expenses from the category of variable costs to thatcosts, HotDog Man increases total annual earnings but the variability of the earnings from month to montincreases. Although the company earns more during the spring and fall by reducing the variable costs, it loseduring the winter months because it must continue to meet its higher fixed costs.

This increase in variability is reflected in the month-to-month standard deviation of earnings, which is shown iexamples directly under the annual sum of earnings. The current cost structure results in a standard devia$4,963, but the projected cost structure has a month-to-month standard deviation of $5,738.


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Firm A 120,000 $2.00 $240,000 $20,000 $1.50 $180,000 $40,000

200,000 $1.70 $340,000 $20,000 $1.50 $300,000 $20,000 ($20,000)

Firm B 120,000 $2.00 $240,000 $40,000 $1.20 $144,000 $56,000

200,000 $1.70 $340,000 $40,000 $1.20 $240,000 $60,000 $4,000

Firm C 120,000 $2.00 $240,000 $60,000 $1.00 $120,000 $60,000

200,000 $1.70 $340,000 $60,000 $1.00 $200,000 $80,000 $20,000

Performing an analysis of the impacts that leverage can have on a firms profitability is essential to a clear picthe risk a company has decided to take on. However, the DOL is only one of the indicators that a mashareholder, or creditor uses to measure the value and risk to a firms financial health. Another important meaa companys degree of financial leverage.

As before, Firm C has a higher DOL than either Firms A or B. Although the managers of Firm C believe that thisto their advantage, they should also perform the same analysis on the downside. If, despite reducing their uniprice, their total sales remain at 120,000 instead of increasing to 200,000, the reduction in unit price wouldprofits by $36,000 instead of increasing them by $20,000. It is for this reason that companies with a high deleverage must be confident that their sales volumes will not fall. Otherwise, they run a significant risk of missinprofit objectives.


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Suppose that you can obtain a loan at 9 percent interest to finance the acquisition of new computer workstatithe return on the assets represented by the new workstations is 12 percent, you will have leveraged the loan,benefit. But if the return on this equipment turns out to be only 6 percent, the leverage works against you: youmore in interest than you will earn from the asset.

Clearly, financial leverage is an important indicator to investors (should I buy this stock?), to managers (decision get me a promotion or a pink slip?), to stockholders (should I sell or stand pat?) and to creditors (carepay this loan?). There are several financial leverage ratios that help you analyze a companys capital strThese ratios include the Debt Ratio and the Times Interest Earned ratio.

If you obtain a loan to finance the purchase of computer workstations for your clients to use during training, yoassumed an additional financial risk, beyond your business risk: the possibility that your firm will be unable tothat loan from its earnings.

It is useful to separate business from financial risk to make decisions pertaining to financial leverage. Onefocus on financial risk is to analyze a firms financial structure: that is, the way that the firm has gone about finits assets. Part of a companys overall financial structure is its capital structure. The companys capital structurcombination of various forms of debt and equity that are used to finance its assets.

A thorough understanding of the debt that your company has assumed significantly enhances your ability togood decisions about acquiring new debt. As a creditor, it is essential to understand a borrowers capital struc

order to measure the risk of making a loan, and to determine whether the interest rate is in line with that risk.

The acquisition of additional debt, of course, changes a companys degree of financial leverage, and therefodebt can have either a beneficial or a detrimental impact on the evaluations made by creditors and stockholders

Analyzing Financial LeverageFinancial leverage is the extent to which a company finances the acquisition of its assets by means of debt: thcompany that borrows money to acquire assets engages financial leverage. This type of leverage is acomponent in the measurement of the financial health and value of a company. It helps managers, anstockholders, as well as long and short-term creditors distinguish between a firms level of business risk afinancial risk that the firm has assumed.

In contrast, financial risk is the additional exposure, above and beyond business risk, that a firm incurs byfinancial leverage: that is, the debt that the firm assumes by financing the acquisition of its assets.

Suppose, for example, that you decide to start a business that offers training classes in the design of busoftware. Your business risk consists of factors such as the desirability of the training, the number of peoplmight want it, the number of other firms that offer similar training classes, the market share of business sosystems that you choose to focus on, and the quality and price of your service relative to that of your competitio


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Total Total Debt

Debt Assets Ratio

Firm A $0 $10,000 0%

Firm B $2,000 $10,000 20%

Firm C $5,000 $10,000 50%

The Debt Ratio is the ratio of total debt to total assets. (Another term for the Debt Ratio is the Leverage Factoexample below calculates the Debt Ratio of three firms that are identical in all respects except for the amountthat they have assumed.

The Debt Ratio measures the proportion of a firms total assets that are financed, both short-term and long-te

means ofcreditors funds. Managers, analysts, shareholders, and creditors use the Debt Ratio as one indicatormuch risk a firm is carrying.

For example, a companys value is in large measure a function of the value of its assets. If a firm has a higratio, then a high proportion of its assets has been financed by means of debt. This implies that the companspend a greater proportion of its earnings to pay off those debts, instead of reinvesting its earnings in the comp

On the other hand, a company with a low debt ratio has used its equity to acquire assets. This implies that it rea smaller proportion of its earnings to retire debt, and the company can make more dollars available for reinveand dividends.

The ratios provide managers, analysts, investors, and creditors with useful indications of how financial leimpacts the level of financial risk a company has assumed. The ratio information is critical for determining the stand even the solvency, of a company.

Determining the Debt Ratio


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EBIT Interest Times Interest

Earned

Firm A $200,000 $30,000 6.7

Firm B $200,000 $50,000 4.0

Firm C $200,000 $100,000 2.0

SummaryIn the business environment of the new millennium, operating and financial leverage are important ingredidetermining the success or demise of many companies. Firms acquire leverage to bolster their financial pothus increasing shareholder value. However, with increased leverage comes increased risk. Managers, an

shareholders, and creditors must be very clear about the implications of the risks associated with a firms opand financial leverage to make investment decisions. Knowing these implications brings their decisions in litheir desired levels of risk.

Times Interest Earned refers to the number of times that interest payments are covered by a firms earningcalculated by dividing the EBIT by interest charges: that is, the income that is available for the payment of individed by the interest expense. Thus, the Times Interest Earned ratio indicates the extent to which a firmsearnings are able to meet current interest payments out of net operating income or EBIT. The example belowpossible Times Interest Earned ratios for three firms.

The Times Interest Earned ratios in the example indicate that Firm A, because it has relatively low debt, usesproportion of its earnings to cover interest payments. Firm B covers annual interest payments four times at itsearnings level, and Firm C covers annual interest payments two times at its current earnings level.

Firm C runs a greater risk of financial difficulty than the other two firms. This is because it must cover ipayments before applying earnings to any other purpose, such as reinvestment.

A firms debt ratio is also a useful indicator of how well it will weather difficult financial times. For examplcompany with a high debt ratio suffers significant earnings losses, it will be hard pressed to continue operatiosimultaneously pay off its debts. But a company with a low debt ratio is in a much better position to cooperations if earnings decrease, because it will not need to use its earnings for debt retirement.

In debt ratio example, Firm C has the highest debt ratio. This implies that if the firm were to experience a recesperiod, the cash flow it generates may not be sufficient to meet principal and interest payments on the debt acIn this example, the Debt Ratio indicates that Firm C is at the greatest financial risk.

The Equity Ratio is the opposite of the Debt Ratio. It returns the ratio of a firms equity to its assets. The higEquity Ratio, the lower a firms financial leverage.

Determining the Times Interest Earned Ratio


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