The effect of the operating leverage and its impact on profit
Effect of operating leverage (production) -this is a rapid change in net profit with an increase in revenue from sales. It occurs under the influence of constant costs for the production process and sale. At the same time, these expenses remain unchanged, and revenue is growing.
The strength of the operating lever shows how muchpercent there will be a change in profit with growth (decrease) in revenue by 1%. The higher the share of expenses (constant) used in production and sales, the more powerfully the lever operates. The formula for its definition is the difference between revenue and costs / profit.
The definition of "lever" is used in varioussciences. This is a special device that allows you to increase the impact on a particular object. In the economy, the role of such a mechanism is fixed costs. The operational lever reveals how much the enterprise depends on the costs included in the cost of production. This indicator characterizes business risk.
The effect of the operating lever is observed,that even a small change in revenue leads to a stronger growth or a decrease in profits. Suppose that the share of costs constant in the cost of production is high, then the firm has a very high level of production leverage. Consequently, business risk is also significant. If such an enterprise even slightly changes the sales volume, it will receive a significant fluctuation in profits.
Each organization has a pointbreak-even. In it, the level of the operating lever tends to infinity. But with a slight deviation of sales from this point, there is a significant change in profitability. And the more deviation from the breakeven point, the lesser the company receives. It should be noted that almost all firms are engaged in the production or sale of several types of products. Therefore, the effect of the operational lever should be considered on the total revenue from sales and for each product (service) separately.
In the case when the growth of permanentcosts, it is necessary to choose a strategy aimed at increasing sales volumes. In this case, even the level of variable costs does not matter. The effect of the operating leverage is affected only by fixed costs. Analysis of it is important for financial managers. Learning the operating leverage helps to choose the right strategy in managing profit, costs and business risk.
There are several factors affecting the level of the production lever:
- the price at which the product is sold;
- volume of sales;
- costs, mostly permanent.
If the market is unfavorableconjuncture, this leads to a decline in sales. Usually such a situation develops at the first stage of the product life cycle. Then the break-even point is not overcome. And this requires a significant reduction in fixed costs, the calculation of financial leverage. Conversely, when the market situation is favorable, you can slightly weaken control over costs. Such a period can be used for the modernization of fixed assets, for investing in new projects, for purchasing assets, and so on.
The branch belonging to the enterprise dictatescertain requirements to the size of investment, labor automation, to the qualifications of specialists, etc. If the organization works in the field of mechanical engineering, heavy industry, then management of the operating leverage is difficult. This is associated with high permanent costs. But if the firm is engaged in providing services, then the regulation of the operating leverage is quite simple.
Purposeful management of variable and constant costs, changing them depending on the situation on the market will reduce business risk and increase the profit of the enterprise.