Chapter 2

OPERATIVE LEVERAGE

by josavere

The investment decisions act as a leader and constitute the starting point for any type of company; the trade and production activities dominates for the human resource .All type of productive activities constitutes what in finances we called the OPERATION. The expression is given to operative leverage which is defined as the relationship between the percentage of increase in the UAII (profit before interests and taxes), divided by the percentage of increase in the sales that originated them.

To this exercise, it is fundamental to initiate the analysis of reviewed balance taking care of the characteristics of each particular company, specifically as far as it concerns mixture of sales, policy of prices, adapted classification of costs, terms of sale and productive cycle including the storage.

Known the point of reviewed balance in terms of units to produce and to sell, pass to analyze the different alternatives that appear with respect to production and sales, as follows:

a. Change of prices

b. Change of terms

c. Change in the mixture of sales

d. Variations in the productive cycle

e. Improvements in the productivity

f. Others

Taking as starting point the amount and price of reviewed balance make a matrix in excel, carefully raising each one of them and the corresponding one individually calculated of the operative profit.

Example: The Company KKKK sells its product mixture at \$ 12000/per unit ready price and offers the following discounts.

 Sales Discount Clients Type A: 40% 2% Clients Type B: 20% 3% Clients Type C: 30% --- Clients Type D: 10% 8%

The term of sale is of 90 days, with a cost of capital to the date of 2, 5% monthly; the activity throws a rotation of inventories to 120 days. The fixed costs are of \$ 10,000,000, and variable costs are handled that represent 55% of the price of list.

1. ANALYSIS OF THE BALANCE POINT

Obtaining the amounts of balance we will have valuable information about the minimum amounts to produce and to sell so that losses do not take place. U = QP - CF - (Q x CV) = (1.852 x 12.000) - 10.000.000 - (1.852 x 6.600)
U = QP - CF - (Q x CV) = 22.224.000 - 10.000.000 - 12.224.000 = 0
 U: profit Q: amount to produce and to sell P: price CF: fixed costs CV: variable costs

2. CALCULATION OF THE POINT OF REVIEWED BALANCE

A. CALCULATION OF THE PRICE AVERAGE OF SALE: it is equivalent to average, which is obtained soon multiplying the participation of each type of clients by the net percentage and affecting the price of list by the obtained result, thus.

(0.40 x 0.98) + (0.20 x 0.97) + (0.30 x 1.00) + (0.10 x 0.92) = 97.8%

97.8% x \$12.000 = 1.173.600 = \$11.736

B. CALCULATION OF THE REVIEWED SALE PRICE: as the company sells at three months, the reviewed sale price is obtained taking to price average to a present value, based on the capital cost.

The objective is to calculate what we would receive if they paid us in cash. Reviewed sale price = \$10.898

C. CALCULATION OF THE REVIEWED VARIABLE COST

Variable cost = \$12.000 x 0.55 = 6.600

The reviewed variable cost is obtained taking the variable cost previous to a future value considering the rotation of inventories and the cost of capital. D. CALCULATION OF THE REVIEWED AMOUNTS OF BALANCE: the contribution margin that represents the margin to cover the costs and fixed expenses and of providing a profit.

Margin of contribution = reviewed price sale - reviewed variable cost

Margin of contribution = \$10.898 - \$7.285 = \$3.613

Next the reviewed amounts of balance will be diving by the fixed costs on the margin of contribution with reviewed sale price and variable cost. 2,767 units are due to produce a minimum to have a margin. 3. EXPOSITION OF ALTERNATIVES

(PLANT CAPACITY: 5,000 UNITS / 12 MONTHS)

ALTERNATIVE A

If by means of a technological development, the company manages to reduce the fixed costs a 15%, and increases the units produced and sold by a 5%, it reduces the cycle of production and sale to 60 days and with one financial restructuring is managed to diminish the cost of capital by 2%, as it will be the new point of balance?

a. Calculation of the reviewed sale price VP = \$11.059 reviewed sale price

b. Calculation of the reviewed cost of sale VF = \$6.866 reviewed cost

FIXED COSTS = \$10.000.000 - (\$10.000.000 x 15%) = \$ 8.500.000

UNITS TO BE PRODUCED AND TO SELL = 2.767 X (1 + 5%) = 2.905 In the previous graph the new point of reviewed balance can be observed; in this last one there was a variation in the fixed cost, in the units to be produced, the cost of the capital and the rotation of inventory in comparison with the initial situation and the operative result could be follows:

 Income = \$11.059 x 2.905 unities = \$32.126.395 - Variable costs = \$6.866 x 2.905 = (\$19.945.730) - Fixed costs = (\$ 8.500.000) \$ 3.680.665

ALTERNATIVE B

The trade department gives a favorable concept to sell 2,000 units to \$8,000 in cash. Is it justified to make the business or not?

2.000 units + 2.905 units = 4.905 units to be produced and to sell

The 2,905 units were taking place and selling initially.

 Additional income = 2.000 unities x \$8.000 = \$16.000.000 Income period bases = 2.905 unities x \$11.059 = \$32.126.395 Total of income in sales = \$48.126.395

NEW PRICE FOR THE MIXTURE OF PRICES

Total income = \$48.126.395 = \$9.812

Total units = 4.905 unit

New variable cost = \$6.866 x 4.905 units = \$33.677.730

ALTERNATIVE C

Appear a new client who like to buy 2,500 units and pays \$ 7,800 to 60 days. Is this alternative being better than the previous one? Why?

As the capacity of the plant is of 5,000 units and the company is producing 2,905, an order of 2,095 units for client B could be accepted.

Additional entrance = 2.095 units x \$7.800 = \$16.341.000

But Client B pays in 60 days, then this income diminish depending on the cost of capital and the term of payment. In order to obtain real the additional income the value that we have we took the value to a present: VP = additional income + income base period

VP = \$15.706.500 + \$32.126.395 = \$47.832.895 Total of income in sales

ALTERNATIVE D

A, client has arranged to buy 1,800 units and she pays them to a term of \$9,000 at 90 days; the capital cost is of 3%.

The company is producing 2,905 and as the client wishes 1,800 altogether they would be producing 4,705 units.

1.800 units x \$9.000 = \$16.200.000 income

But client C pays in 90 days, then the previous income take to a present value, discounting according to the term and to the cost of capital. VP = additional income + income previous period

VP = \$14.825.295 + \$32.126.395 = \$46.951.690 total of income by sales

ALTERNATIVE E

A client has arranged to buy 2,095 units and she pays them to \$8,200 in cash. The company is producing 2,905 and as the client wishes 2,095 altogether it would be using the total of the capacity of the plant.

 Additional income: 2.095 units x \$8.200 = \$17.179.000 Income previous period: 2.905 units x \$11.059 = \$32.126.395 Total of income in sales = \$49.305.395
 PRICE FOR THE MIXTURE OF SALES = \$49.305.395 5000 unit = \$9.861 4. ANALYSIS OF THE ALTERNATIVES

 Alternatives A B C D E Sales \$32.126.395 \$48.126.395 \$47.832.895 \$46.951.690 \$49.305.395 - Variable costs \$19.945.730 \$33.677.730 \$34.330.000 \$32.304.530 \$34.330.000 Margin \$12.180.665 \$14.448.665 \$13.502.895 \$14.647.160 \$14.975.395 - Fixed costs \$ 8,500,000 \$8,500,000 \$8.500.000 \$8,500,000 \$8,500,000 UAII \$ 3.680.665 \$5.948.665 \$5.002.895 \$ 6.147.160 \$ 6.475.395 The LEVERAGE indicates to us that if there is an increase in sales, whichever being the increase in UAII. For example for alternatives C and D as they have a similar leverage if for example there is an increase in the sales by 20%, the UAII will make a 20% 1,4 = 28%. Whereas for the alternative B it has a 0, 74 leverage, and if there were an increase in the sales by 20%, the UAII will have a smaller increase than the one of sales 20% x 0, 7 = 14%.

Having a high degree of operative leverage does not mean that the good company is in a good situation. This figure gives to a so beneficial idea that could be the increase in the sales or the dangerous thing that could be a decrease.

The leverage gives an idea of the operative risk which a certain structure of costs and fixed expenses the company incurs.

A high degree of leverage in circumstances is advantageous, but it implies a greater operative risk.

5. APPLICATION OF THE SYSTEMS OF COSTS

We briefly remembered the functioning of the systems of costs, which can be transformed in two:

1. To constitute a basic tool for the making of decisions and evaluation after the exercise.

For it the following recognized system exists as follows:

2. To serve as bases to inform the government the results of the exercise and to calculate the profit (micron or macroeconomic).

A. TOTAL COST: also called, by absorption which adds the costs of the period to the produced units as the process advances. It is understood by costs of the period those that appear in function of the time, independently of whether it takes place or not. It is the case of the fixed costs like: renting, part of the public services, monitoring, some headings, etc.

These costs add to the product, using base recommendable as for the particular case. Among others they can be, hours of manual labor, prime cost (raw materials + direct manual labor), produced units, etc.

It allows calculating the total costs without omitting it and is very useful to know all the components, when the plant capacity is full.

B. DIRECT COST: it considers as components to the cost, only the identifiable elements with the product namely, direct materials and direct manual labor. The difference between the direct sale price and costs is called margin of contribution. The margin of contribution must be sufficient to cover the costs with the period (fixed) and to contribute to the profit margin that company delays to obtain in the sale.

It demands a high dose of prevision because the company must have the sufficient maturity in the systems of planning, stops of that form to calculate with stop index of certainty, the volume of fixed expenses that are due to absorb with the amount to sell, later to add the profit. Useful for companies with capacity of idle plant is specially that allows establishing prices differentials to penetrate in new markets.

C. ABC COSTS: in determined occasions, specifically in the sector of services (banks, financial institutions, hospitals, insurance, etc). Is important to measure the value of each productive activity and charging the fulfilled costs for each one.

The different systems of costs have advantages and also limitations. For the decision making and to process models of planning it is advisable not to cling to a system in individual, but to use the combinations that allow obtaining the objectives of company to a short, medium and long term.

D. SUMMARIZE: analysis of the operative leverage begins with an analysis of balance reviewing carefully the assumptions on that the model in particular case is based and doing the pertinent adjustments.

In general, must review the list price and the costs affected by inherent the financial expenses to the time of process and storage.

Based on the reviewed point of balance prepared a scene with the different alternatives as one acquires knowledge in the final panel of the exercise (analysis of alternatives).

The company must decide on the best alternative of operative type that it allows obtaining the best level of profits before interest and taxes.

Taking as a reference the alternative from smaller operative profits, calculated the percentage increase in the sales.

And come from the same form with the increase in the operative profit. The degree of operative leverage is divided by the relationship between the previous results, as follows: It is interpreted as the times that the operative profit by a unitary increase in the sales increases.