Principles of Managerial Finance

512 PART 4 Long-Term Financial Decisions

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

0 500 1,000 1,500 2,000 2,500 3,000

Q 1 Q 2

Sales (units)

Costs/Revenues ($)

EBIT 1

($2,500)

EBIT 2

($5,000)

Loss

EBIT

Fixed

Operating

Cost

Total

Operating

Cost

Sales

Revenue

FIGURE 12.2

Operating Leverage
Breakeven analysis and
operating leverage

operating leverage
The potential use of fixed operat-
ing coststo magnify the effects
of changes in sales on the firm’s
earnings before interest and
taxes.

(3) Operating breakeven point1,000 units

(4) Operating breakeven point600 units

Comparing the resulting operating breakeven points to the initial value of 500

units, we can see that the cost increases (actions 1 and 3) raise the breakeven

point, whereas the revenue increase (action 2) lowers the breakeven point. The

combined effect of increasing all three variables (action 4) also results in an

increased operating breakeven point.

We now turn our attention to the three types of leverage. It is important to

recognize that the demonstrations of leverage that follow are conceptual in

nature and that the measures presented are notroutinely used by financial man-

agers for decision-making purposes.

Operating Leverage

Operating leverage results from the existence of fixed operating costsin the firm’s

income stream. Using the structure presented in Table 12.2, we can define operat-

ing leverageas the potential use of fixed operating coststo magnify the effects of

changes in sales on the firm’s earnings before interest and taxes.

$3,000



$12.50$7.50

$2,500



$10$7.50