The activities of almost any company are subject to risks. To achieve its goals, the company develops predictive financial indicators, including forecasts for revenue, cost, profit, etc. In addition, the company attracts financial resources for the implementation of investment projects. Therefore, the owners expect that the assets will bring additional profit and provide a sufficient level of return on invested capital. (return on equity, ROE):
where NI (net income)- net profit; E (equity) is the equity capital of the company.
However, due to competition in the market, ups and downs of the economy, a situation arises when the actual values of revenue and other key indicators differ significantly from the planned ones. This type of risk is called operational (or production) risk (business risk), and it is associated with the uncertainty of obtaining operating income of the company due to changes in the situation on the sales market, falling prices for goods and services, as well as rising tariffs and tax payments. The rapid obsolescence of products has a great influence on production risks in the modern economy. Production risk leads to uncertainty in planning the profitability of the company's assets ( return on assets, ROA):
where A (assets)– assets; I (interests)- Percentage to be paid. In the absence of debt financing, the interest payable is zero, so the value ROA for a financially independent company is equal to the return on equity (ROE) and a company's production risk is determined by the standard deviation of its expected return on equity, or ROE.
One of the factors affecting the production risk of a company is share of fixed costs in its general operating expenses, which must be paid regardless of how much revenue its business generates. To measure the degree of influence of fixed costs on the company's profits, you can use the indicator of operating leverage, or leverage.
Operating lever (operating leverage) due to the company's fixed costs, as a result of which a change in revenue causes a disproportionate, stronger decrease or increase in the return on equity.
A high level of operating leverage is characteristic of capital-intensive industries (steel, oil, heavy engineering, forestry), which incur significant fixed costs, such as the maintenance and maintenance of buildings and premises, rental costs, fixed general production costs, utility bills, salaries of management personnel, tax on property and land, etc. The peculiarity of fixed costs is that they remain unchanged and with the growth of production volumes, their value per unit of output decreases (the effect of scale of production). At the same time, variable costs increase in direct proportion to the growth of production, however, per unit of output, they are a constant value. To study the relationship between a company's sales volume, expenses and profit, a break-even analysis is carried out, which allows you to determine how much goods and services need to be sold in order to recover fixed and variable costs. This quantity of goods and services sold is called breakeven point (break-even point), and the calculations are carried out within break-even analysis (break-even analysis). The break-even point is the critical value of the volume of production, when the company is not yet making a profit, but is no longer incurring losses. If sales rise above this point, then a profit is formed. To determine the break-even point, first consider Fig. 9.4, which shows how the operating profit of the company is formed.
Rice. 9.4.
The break-even point is reached when the revenue covers operating expenses, i.e. operating profit is zero, EBIT= 0:
where R– selling price; Q- the number of units of production; V- variable costs per unit of output; F- total fixed operating costs.
where is the breakeven point.
Example 9.2. Let us assume that Charm, a cosmetics company, has a fixed cost of RUB 3,000, a unit price of RUB 100, and a variable cost of RUB 60. per unit. What is the breakeven point?
Solution
We will carry out the calculations according to the formula (9.1):
In Example 9.2, we showed that the company needs to sell 75 units. products to cover their operating expenses. If you manage to sell more than 75 units. product, then its operating profit (and therefore, ROE in the absence of debt financing) will begin to grow, and if it is less, then its value will be negative. At the same time, as is clear from formula (9.1), the break-even point will be the higher, the greater the size of the company's fixed costs. A higher level of fixed costs requires more products to be sold in order for the company to start making a profit.
Example 9.3. It is necessary to conduct a break-even analysis for two companies, data for one of them - "Sharm" - we considered in example 9.2. The second company - "Style" - has higher fixed costs at the level of 6000 rubles, but its variable costs are lower and amount to 40 rubles. per unit, the price of products is 100 rubles. for a unit. The income tax rate is 25%. Companies do not use debt financing, so the assets of each company are equal to the value of their own capital, namely 15,000 rubles. It is required to calculate the break-even point for the company "Style", as well as to determine the value ROE for both companies with sales volumes of 0, 20, 50, 75, 100, 125, 150 units. products.
Solution
First, let's determine the break-even point for the Style company:
Let's calculate the value of the return on equity of companies for different sales volumes and present the data in Table. 9.1 and 9.2.
Table 9.1
Sharm company
Operating costs, rub. |
Net profit, rub., EBIT About -0,25) |
ROE, % NI/E |
|||
Table 9.2
Company "Style"
Operating costs, rub. |
Net profit, rub., EBIT (1 -0,25) |
ROE, % NI/E |
|||
Due to Style's higher fixed costs, the break-even point is reached at a higher sales volume, so the owners need to sell more products to make a profit. It is also important for us to look at the change in profit that occurs in response to a change in sales, for this we will build graphs (Fig. 9.5). As you can see, due to lower fixed costs, the break-even point for the company "Sharm" (chart 1) is lower than for the company "Style". For the first company, it is 75 units, and for the second - 100 units. After the company sells products in excess of the break-even point, revenue covers operating costs and additional profit is formed.
So, in the considered example, we have shown that in the case of a higher share of fixed costs in costs, the break-even point is reached with a larger volume of sales. After reaching the break-even point, the profit begins to grow, but as is clear from Fig. 9.4, in the case of higher fixed costs, profit grows faster for Style than for Charm. In the case of a decrease in activity, the same effect occurs, only a decrease in sales leads to the fact that losses grow faster for a company with higher fixed costs. Thus, fixed costs create a leverage that, when production increases or decreases, causes more significant changes in profit or loss. As a result, the values ROE deviate more for companies with higher fixed costs, which increases risk. Using the calculation of the effect of operating leverage, you can determine how much the operating profit will change when the company's revenue changes. Operating leverage effect (degree of operating leverage, DOL) shows by what percentage the operating profit will increase / decrease if the company's revenue increases / decreases by 1%:
where EBIT- operating profit of the company; Q- sales volume in units of production.
At the same time, the higher the share of fixed costs in the company's total operating expenses, the higher the strength of the operating leverage. For a specific volume of production, the operating leverage is calculated by the formula
(9.2)
If the value of the operating leverage (leverage) is equal to 2, then with an increase in sales by 10%, operating profit will increase by 20%. But at the same time, if the sales revenue decreases by 10%, then the company's operating profit will also decrease more significantly - by 20%.
Rice. 9.5.
If the brackets are opened in formula (9.2), then the value QP will correspond to the company's revenue, and the value QV- total variable costs:
where S- the company's revenue; TVС- total variable costs; F- fixed costs.
If a company has a high level of fixed costs in general expenses, then the value of operating income will change significantly with revenue fluctuations, and there will also be a high dispersion of the return on equity compared to a company that produces similar products, but has a lower level of operating leverage.
The results of the company's activities largely depend on the market situation (changes in GDP, fluctuations in interest rates, inflation, changes in the exchange rate of the national currency, etc.). If the company is characterized by high operating leverage, then a significant proportion of fixed costs enhances the consequences of negative changes in the markets, increases the company's risks. Indeed, variable costs will decrease following the decline in production caused by market factors, but if fixed costs cannot be reduced, then profits will decline.
Is it possible to reduce the level of production risk of the company?
To some extent, companies can influence the level of their operating leverage by controlling the amount of fixed costs. When choosing investment projects, a company can calculate the break-even point and operating leverage for different investment plans. For example, a trading company can analyze two options for selling household appliances - in shopping centers or via the Internet. Obviously, the first option involves high fixed costs for renting trading floors, while the second trading option does not involve such costs. Therefore, in order to avoid high fixed costs and the risk associated with them, the company can provide a way to reduce them during the project development stage.
To reduce fixed costs, the company may also switch to subcontracts with suppliers and contractors. The experience of Japanese companies using subcontracting is widely known, in which a significant part of the production of components is transferred to subcontractors, the parent company concentrates on the most complex technological processes, and fixed costs are reduced due to the withdrawal of individual capital-intensive industries to subcontractors. The importance of managing fixed costs is also related to the fact that their share has a great influence on the financial leverage, on the formation of the capital structure, which we will discuss in the next paragraph.
Financial leverage is the ratio of a company's borrowed capital to its own budget. Thanks to him, you can study the financial position of the company, the degree of risk of the collapse of the enterprise or the likelihood of its success. The lower the leverage, the more stable the company's position. But do not forget that with the help of a loan, many small enterprises grow into larger ones, and large ones, having received additional profit to their own capital, improve their position.
Purpose of financial leverage
Financial leverage in the economy can be called credit leverage, leverage, financial leverage, but the meaning does not change. A lever in physics helps to lift heavier objects with less effort, and it is the same in economics. The coefficient of financial leverage allows you to get a big profit. At the same time, it takes less time and effort to fulfill a dream. Sometimes you can also find such a definition: "Financial leverage is an increase in the profitability of an enterprise's personal income due to the use of borrowed funds."
Changing the structure of the company's capital (shares of own and borrowed funds) allows you to increase the company's net profit. As a rule, the additional capital received as a result of the work of leverage is used to create new assets, improve the performance of the company, expand branches, etc.
The more money circulates within the enterprise, the more expensive cooperation with the owners for investors and shareholders, and this, of course, plays into the hands of CEOs.
Based on the concept of leverage, it can be argued that the effect of financial leverage is the ratio of borrowed capital to own profit, expressed as a percentage.
Who needs to know what leverage is and why?
It is important not only for investors and lenders to understand and be able to evaluate the structure of the investment market. However, for an investor or a banker, the amount of leverage serves as an excellent guide for further cooperation with the company and the size of lending rates.
Entrepreneurs themselves, company owners, financial managers need to know the structure of leverage and be able to evaluate it in order to understand the financial condition of the company and dependence on external loans. If inexperienced entrepreneurs neglect the knowledge of credit leverage, they can easily lose financial independence due to large loans and external debts. If the directors decide that the company is developing well even without a credit history, then they will miss the opportunity to increase the return on assets, which means they will slow down the process of lifting the enterprise on the “career ladder”.
External borrowing allows a company to increase productivity faster and more efficiently, but it can also draw it into an economic dependence on loans.
It is also worth remembering that an entrepreneur should never take unjustified loans (unnecessary for a given stage of company development). When applying for a loan, it is necessary to accurately represent the amount of funds needed to expand the enterprise or increase sales.
The formula for financial leverage.
There are many nuances in the economy, without knowing which, beginners easily fall for credit tricks and do not achieve their goals, blaming financial leverage for everything. Its formula should be firmly rooted in the brain of both business newbies and professionals.
EGF \u003d (1 - Cn) x D x FR
EFR - the effect of financial leverage;
Сн - direct tax on the profit of the organization, expressed in decimal fraction (may vary depending on the type of activity of the enterprise);
D - differential, the difference between the profitability ratio (CR) of assets and the percentage of the loan rate;
FR - financial leverage, the ratio of the average borrowed capital of the enterprise to the value of its own.
Patterns of Leverage
In accordance with the formula, several patterns of leverage can be derived.
The differential must always be positive. This is an important impulse for the operation of credit leverage, which allows the borrower to understand the degree of risk of lending large amounts to an entrepreneur. The higher the indicator, the lower the risk for the banker.
The shoulder (FR) also contains fundamentally important information for both participants in the process. The larger it is, the higher the risk for both the banker and the entrepreneur.
Based on these two aspects, it is clear how leverage helps to improve profitability. Financial leverage serves to increase not only one's own profit, but also to determine the amount of credit that an entrepreneur can attract.
Average leverage
Practical methods were used to determine the optimal value of the financial leverage indicator (as a percentage). For an average enterprise, the ratio of borrowed funds to equity is from 50 to 70%. With a decrease in this indicator by at least 10%, the entrepreneur’s chance to develop his company and achieve success is lost, and with an increase to 80 or 90%, the financial independence of the entire enterprise is put at great risk.
However, do not forget that the normal level of leverage also depends on the industry, scale (business size, number of branches, etc.) and even on the method of organizing management and approach to building the structure of the company.
The main components of financial leverage
Financial leverage largely depends on secondary factors. Each of them must be analyzed separately. The indicator of financial leverage is equal to the ratio of credit capital to equity capital. Consequently, the factor that changes the indicator of the leverage effect in the first place is the return on assets, that is, the ratio of the net profit of the enterprise (for the year) to the value of all assets (the balance of the enterprise).
The financial leverage ratio is the leverage showing what share in the overall structure of the company is occupied by borrowed or other funds that are obligatory for payment (loans, courts, etc.). With the help of leverage, the strength of influence on the net profit of borrowed funds is determined.
Why do you need a tax corrector?
When using financial leverage in calculations, experienced economists turn to such a definition as a tax corrector. Thanks to him, you can find out how the effect of financial leverage changes with an increase or decrease in income tax. Recall that all legal entities of the Russian Federation (JSC, CJSC, etc.) pay income tax, and its rate is different and depends on the type of activity and the amount of real income. So, the tax corrector is used only in three cases:
- If there are different rates of taxation;
- If the company uses benefits (for certain types of activities);
- If subsidiaries (branches) are located in free economic zones of the state, where there is a preferential regime, or branches are located in foreign countries with the same zones.
Thus, with a decrease in the tax burden for one of these reasons, the dependence of the effect of financial leverage on the corrector noticeably decreases.
Operating leverage
Operational and financial leverage in the stock market go hand in hand. The indicator of the first indicates changes in the growth rate of profit from sales. If you know what operating leverage is, you can predict with great accuracy the change in profit for the year with a change in the monthly revenue indicator.
In the market there is the concept of the break-even point, showing the amount of income needed to cover expenses. At this point, if displayed on a coordinate line, net profit is zero, the left side is negative (the company incurs losses), the right side is positive (the company covers expenses and net profit remains). This straight line is called an indicator of the company's financial strength.
Operating leverage effect
The strength with which the operating lever operates in the enterprise depends on the average weight of fixed costs in the total cost of costs (fixed and variable). So, the effect of the production lever is the most important indicator of the budget risk of an enterprise, calculated according to the following formula:
- EOR \u003d (DVP + PR) / DVP
- EOR - the effect of operating leverage;
- DVP - income before interest (taxes and debts);
- PR - fixed costs of production (the indicator does not depend on revenue).
Why is the effectiveness of financial leverage reduced?
The financial leverage of an enterprise, of course, shows how competently the owner handles his own and borrowed funds, but there is always a risk, especially when there are problems with the economic situation in the market. So under what factors does the effectiveness of financial leverage decrease and why does this happen?
During the deterioration of the financial situation in the market, the cost of attracting a loan increases sharply, which, of course, will affect the indicator of financial leverage, depending on the choice of the entrepreneur: to take a loan at new rates or use their own income.
Decreased financial stability of the company due to the economic crisis or inept handling of money (permanent loans, large expenses) leads to an increased risk of bankruptcy of the company. Interest rates for such people are rising, which means that the indicator of financial leverage is decreasing. Sometimes it can go to zero or take a negative value.
A decrease in demand for a product leads to a decrease in income. This is how the return on assets falls, and this factor is the most important in the formation of financial leverage.
This leads to the conclusion that the effectiveness of financial leverage falls due to external factors (position on the market), and not through the fault of the entrepreneur or accountants.
Entrepreneurship - risk or delicate work?
Thus, the financial lever determines the most important indicator of the state of the enterprise in the economy, is calculated as the ratio of borrowed capital to equity and has the so-called average value from 50 to 70%, depending on the type of activity. However, many young entrepreneurs, due to their inexperience, do not attach due importance to leverage and do not notice how they become financially dependent on larger corporations or bankers.
That is why people who connect their lives with the economy and the stock market need to know all the subtleties, nuances and aspects of entrepreneurship.
- Gurfova Svetlana Adalbievna, Candidate of Sciences, Associate Professor, Associate Professor
- Kabardino-Balkarian State Agrarian University named after V.I. V.M. Kokova
- OPERATING LEVER POWER
- OPERATING LEVER
- VARIABLE COSTS
- OPERATIONAL ANALYSIS
- FIXED COSTS
The ratio "Volume - Costs - Profit" allows you to quantify changes in profit depending on sales volume based on the mechanism of operating leverage. The operation of this mechanism is based on the fact that profit always changes faster than any change in the volume of production, due to the presence of fixed costs as part of operating costs. In the article, using the example of an industrial enterprise, the magnitude of the operating leverage and the strength of its impact are calculated and analyzed.
- Characteristics of approaches to the definition of the concept of "financial support of the organization"
- Financial and economic state of Kabarda and Balkaria in the post-war period
- Features of the nationalization of industrial and commercial enterprises in Kabardino-Balkaria
- Influence of the sustainability of agricultural formations on the development of rural areas
One of the most effective methods of financial analysis for the purpose of operational and strategic planning is operational analysis, which characterizes the relationship between financial performance and costs, production volumes and prices. It helps to identify the optimal proportions between variable and fixed costs, price and sales volume, minimizing entrepreneurial risk. Operational analysis, being an integral part of management accounting, helps the financiers of the enterprise to get answers to many of the most important questions that arise before them at almost all the main stages of the organization's cash flow. Its results may constitute a trade secret of the enterprise.
The main elements of operational analysis are:
- operating lever (leverage);
- profitability threshold;
- stock of financial strength of the enterprise.
Operating leverage is defined as the ratio of the rate of change in sales profit to the rate of change in sales revenue. It is measured in times, shows how many times the numerator is greater than the denominator, that is, it answers the question of how many times the rate of change in profit exceeds the rate of change in revenue.
Let's calculate the amount of operating leverage based on the data of the analyzed enterprise - JSC "NZVA" (Table 1).
Table 1. Calculation of the operating leverage at OJSC NZVA
Calculations show that in 2013. the rate of change in profit was approximately 3.2 times higher than the rate of change in revenue. In fact, both revenue and profit changed upwards: revenue - by 1.24 times, and profit - by 2.62 times compared to the level of 2012. At the same time, 1.24< 2,62 в 2,1 раза. В 2014г. прибыль уменьшилась на 8,3%, темп ее изменения (снижения) значительно меньше темпа изменения выручки, который тоже невелик – всего 0,02.
For each specific enterprise and each specific planning period, there is its own level of operating leverage.
When a financial manager pursues the goal of maximizing the rate of profit growth, he can influence not only variable costs, but also fixed costs by applying increment or decrement procedures. Depending on this, he calculates how the profit has changed - increased or decreased - and the magnitude of this change as a percentage. In practice, to determine the strength of operating leverage, a ratio is used in which the numerator is sales revenue minus variable costs (gross margin), and the denominator is profit. This figure is often referred to as the coverage amount. It is necessary to strive to ensure that the gross margin covers not only fixed costs, but also forms a profit from sales.
To assess the impact of a change in sales revenue on profit, expressed as a percentage, the percentage of revenue growth is multiplied by the strength of the impact of operating leverage (COR). Let's determine the SVOR at the assessed enterprise. The results are presented in the form of table 2.
Table 2. Calculation of the force of the impact of the operating lever on JSC "NZVA"
As shown in Table 2, the amount of variable costs for the analyzed period increased steadily. Yes, in 2013. it amounted to 138.9 percent compared to the level of 2012, and in 2014. - 124.2% compared to the level of 2013. and 172.5% to the level of 2012. The share of variable costs in the total costs for the analyzed period is also steadily increasing. Share of variable costs in 2013 increased compared to 2012. from 48.3% to 56%, and in 2014. - another 9 percentage points compared to the previous year. The force with which the operating lever acts steadily decreases. In 2014 it decreased by more than 2 times compared with the beginning of the analyzed period.
From the point of view of the financial management of the organization's activities, net profit is a value that depends on the level of rational use of the financial resources of the enterprise, i.e. the direction of investment of these resources and the structure of sources of funds are very important. In this regard, the volume and composition of fixed and working capital, as well as the effectiveness of their use, are being studied. Therefore, the change in the level of strength of the operating leverage was also influenced by the change in the structure of the assets of NZVA OJSC. In 2012 the share of non-current assets in the total assets amounted to 76.5%, and in 2013. it increased to 92%. The share of fixed assets accounted for 74.2% and 75.2%, respectively. In 2014 the share of non-current assets decreased (to 89.7%), but the share of fixed assets increased to 88.7%.
It is obvious that the greater the share of fixed costs in the total volume of costs, the greater the force of the production lever and vice versa. This is true when sales revenue increases. And if sales revenue decreases, then the force of production leverage, regardless of the share of fixed costs, increases even faster.
Thus, we can conclude that:
- the structure of the organization's assets, the share of non-current assets, has a significant impact on the SVOR. With the growth of the cost of fixed assets, the proportion of fixed costs increases;
- a high proportion of fixed costs limits the ability to increase the flexibility of current cost management;
- with the increase in the force of the impact of the production lever, the entrepreneurial risk increases.
The SVOP formula helps answer the question of how sensitive the gross margin is. Later, by progressively transforming this formula, we will be able to determine the strength with which operating leverage operates, based on the price and magnitude of variable costs per unit of goods, and the total amount of fixed costs.
The strength of the impact of the operating leverage, as a rule, is calculated for a known volume of sales, for a given specific sales proceeds. With a change in sales revenue, the strength of the impact of operating leverage also changes. SIDS is largely determined by the influence of the average industry level of capital intensity as an objective factor: with the growth in the cost of fixed assets, fixed costs increase.
However, the effect of production leverage can still be controlled using the dependence of the SVOP on the amount of fixed costs: with an increase in fixed costs and a decrease in profits, the effect of the operating lever increases, and vice versa. This can be seen from the transformed formula for the force of the operating lever:
VM / P \u003d (Z post + P) / P, (1)
where VM– gross margin; P- profit; Z post- fixed costs.
The strength of operating leverage increases with an increase in the share of fixed costs in the gross margin. At the analyzed enterprise in 2013. the share of fixed costs decreased (since the share of variable costs increased) by 7.7%. Operating leverage decreased from 17.09 to 7.23. In 2014 - the share of fixed costs decreased (with an increase in the share of variable costs) by another 11%. Operating leverage also decreased from 7.23 to 6.21.
With a decrease in sales revenue, an increase in SVOR occurs. Each percentage decrease in revenue causes an increasing decrease in profits. This reflects the strength of the operating leverage.
If, on the other hand, sales revenue increases, but the break-even point has already been passed, then the operating leverage decreases, and faster and faster with each percentage increase in revenue. At a small distance from the threshold of profitability, the SRR will be maximum, then it will again begin to decrease until the next jump in fixed costs with the passage of a new point of cost recovery.
All these points can be used in the process of forecasting income tax payments in the course of optimizing tax planning, as well as in developing detailed components of the company's commercial policy. If the expected dynamics of sales revenue is sufficiently pessimistic, then fixed costs should not be increased, since the decrease in profit from each percentage decrease in sales revenue can become many times greater as a result of the cumulative effect caused by the influence of large operating leverage. However, if an organization assumes an increase in demand for its goods (works, services) in the long term, then it can afford not to save heavily on fixed costs, since a large share of them is quite capable of providing a higher increase in profits.
In circumstances that contribute to a decrease in the income of the enterprise, it is very difficult to reduce fixed costs. In other words, a high proportion of fixed costs in their total amount indicates that the enterprise has become less flexible, and, therefore, more weakened. Organizations often feel the need to move from one area of activity to another. Of course, the possibility of diversification is at the same time a tempting idea, but also very difficult in terms of organization, and especially in terms of finding financial resources. The higher the cost of tangible fixed assets, the more reasons the company has to stay in its current market niche.
In addition, the state of the enterprise with a high share of fixed costs significantly increases the effect of operating leverage. In such conditions, a decrease in business activity means for the organization a multiplied loss of profit. However, if the revenue grows at a sufficiently high rate, and the company has a strong operating leverage, then it will be able not only to pay the necessary amounts of income tax, but also to ensure good dividends and proper financing of its development.
SVOR indicates the degree of entrepreneurial risk associated with a given business entity: the greater it is, the higher the entrepreneurial risk.
In the presence of a favorable market situation, an enterprise characterized by a greater strength of the operating leverage (high capital intensity) receives an additional financial gain. However, capital intensity should be increased only in the case when an increase in the volume of sales of products is really expected, i.e. with great care.
Thus, by changing the growth rate of sales volume, it is possible to determine how the amount of profit will change with the force of operating leverage that has developed at the enterprise. The effects achieved at enterprises will vary depending on variations in the ratio of fixed and variable costs.
We have considered the mechanism of operation of the operating lever. Its understanding allows for purposeful management of the ratio of fixed and variable costs and, as a result, to improve the efficiency of the current activities of the enterprise, which actually involves the use of changes in the value of the strength of the operating lever under various trends in the commodity market and different stages of the cycle of functioning of an economic entity.
When product market conditions are not favorable, and the company is in the early stages of its life cycle, its policy should identify possible measures that will help reduce the strength of operating leverage by saving fixed costs. With favorable market conditions and when the enterprise is characterized by a certain margin of safety, the work on saving fixed costs can be significantly weakened. During such periods, the enterprise may be recommended to expand the volume of real investments on the basis of the comprehensive modernization of fixed production assets. Fixed costs are much more difficult to change, so enterprises with greater operating leverage are no longer flexible enough, which negatively affects the effectiveness of the cost management process.
The SIDS, as already noted, is significantly affected by the relative value of fixed costs. For enterprises with heavy fixed assets, high values of the operating leverage indicator are very dangerous. In the process of an unstable economy, when customers are characterized by low effective demand, when the strongest inflation takes place, every percent reduction in sales revenue entails a catastrophic, wide-ranging drop in profits. The company is in the loss zone. Management seems to be blocked, that is, the financial manager cannot use most of the options for choosing the most effective and productive managerial and financial decisions.
The introduction of automated systems relatively weighs down fixed costs in the unit cost of production. Indicators react differently to this circumstance: gross margin ratio, profitability threshold and other elements of operational analysis. Automation, with all its advantages, contributes to the growth of entrepreneurial risk. And the reason for this is the tilt of the cost structure towards fixed costs. When an enterprise implements automation, it should carefully weigh its investment decisions. It is necessary to have a well-thought-out long-term strategy for the organization. Automated production, having, as a rule, a relatively low level of variable costs, increases operating leverage as a measure of the involvement of fixed costs. And because of the higher profitability threshold, the margin of financial safety is usually lower. Therefore, the overall level of risk caused by production and economic activities is higher with the intensification of capital than with the intensification of direct labor.
However, automated production implies greater opportunities for effective management of the cost structure than with the use of predominantly manual labor of workers. If there is a wide choice, the business entity must independently determine what is more profitable to have: high variable costs and low fixed costs, or vice versa. It is not possible to unequivocally answer this question, since any option is characterized by both advantages and disadvantages. The final choice will depend on the initial position of the analyzed enterprise, what financial goals it intends to achieve, what are the circumstances and features of its functioning.
Bibliography
- Blank, I.A. Encyclopedia of financial manager. T.2. Management of assets and capital of the enterprise / I.A. Form. - M .: Publishing house "Omega-L", 2008. - 448 p.
- Gurfova, S.A. - 2015. - V. 1. - No. 39. - P. 179-183.
- Kozlovsky, V.A. Production and operational management / V.A. Kozlovsky, T.V. Markina, V.M. Makarov. - St. Petersburg: Special Literature, 1998. - 336 p.
- Lebedev, V. G. Cost management at the enterprise / V. G. Lebedev, T. G. Drozdova, V. P. Kustarev. - St. Petersburg: Peter, 2012. - 592 p.
When compiling a budget, it is worthwhile to figure out how the company's profit is dependent on its revenue, how it will change with an increase or decrease in sales. The key indicator that allows you to make such a forecast is the operating (production) leverage.
Important in the article:
- Operating lever. Calculation formula
- Calculation of the production leverage (operating leverage)
- Manufacturing Lever
How to Calculate Operating Leverage
Formula. Calculation of the production leverage (operating leverage)
For example, a leverage value of 10 percent indicates that profits increase or decrease by that many percent when sales revenue increases or decreases by 1 percent. The higher the production leverage, the faster the company increases profits.
What affects the level of production leverage (leverage)
The production leverage (leverage) depends on - ratio. The more fixed costs in the company's expenses, the higher it is. Accordingly, companies with low production leverage are dominated by variable costs (how to quickly analyze costs, see).
It is worth noting that this indicator characterizes, on the one hand, the possible growth rate of profit, on the other hand, the rate of its decline. At , a company with a large value of production leverage (a high share) will be able to increase profits faster than a company with a low level of this indicator. But in the reverse situation, when the first company falls, it will lose profits at a much greater rate. The higher the production lever, the stronger the company's dependence on the volume of sales of products (how to determine the critical point, see).
What level of production leverage is optimal for the company
To figure out what value of the production lever you need to strive for - high or low, you have to form a forecast for the company's future sales volumes (see how to do this).
With a high risk of falling sales, low production leverage (in other words, a low share of fixed costs) is beneficial, since with a reduction in sales, it is necessary to solve the problem of minimizing profit losses. And vice versa, with favorable market conditions, growth in sales volumes, a high leverage is beneficial (in other words, a high share of fixed, low share of variable costs). This cost structure contributes to profit maximization.
How to optimize production leverage
Timely, that is, the ratio of variable and fixed costs, will help to correctly manage the production lever of the company. At the same time, it is necessary to study each one in detail and evaluate it from the point of view of dependence on the volume of sales (how to evaluate their impact on the cost price, see Fig.