Cost Profit Planning
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Transcript of Cost Profit Planning
8/6/2019 Cost Profit Planning
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LEVERAGE ANALYSIS
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LEVERAGE
yResults from the use of fixed-cost assets or
funds to magnify returns to the firmsowners.
y Generally :y Increases in leverage result in increased return and risk
y Decreases in leverage result in decreased return and risk
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LEVERAGEy The amount of leverage in the firms capital structure
can significantly affect its value by affecting return and
risk.y Unlike some causes of risk, management has almost
complete control over the risk introduced through theuse of leverage.
yBecause of its effect in value, the financial managerunderstand how to measure and evaluate leverage,particularly in making capital structure decision.
y **CAPITAL STRUCTURE the mix of long-term debt and
equity maintained by the firm
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THREE BASIC TYPES
y1. OPERA TING LEVERAGE
y2. FINANCIAL LEVERAGE
y3. TOT AL LEVERAGE
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General Income Statement Format and T ypes of
Leverage
Sales Revenue
Less: Cost of Goods Sold
Gross Profit
Less: Operating ExpensesEarnings before interest and Taxes (EBIT)
Less: Interest
Net Profits before taxes
Less: Taxes
Net Profits after taxesLess: Preferred stock dividends
Earnings Available for common stockholders
Earnings per share (EPS)
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Operating
Leverage
Financial
Leverage
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Operating Leveragey Is the ratio of a companys level of fixed costs to total
costs at different levels of safety or activity.
y A company has a high operating leverage if its costs isconsists mainly of fixed costs
y FOR EXAMPLE:
y A capital-intensive plant has a high operating leverage.
Another company may choose to set up its plant as ahigh labor, low capital plant. Such a company has a lowoperating leverage.
y The use of fixed cost to make operations more efficient
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Operating Leveragey The measure of operating leverage is the degree of
operating leverage (DOL).
y DOL is the percentage change in profit for each
percentage change in output.y FORMULA:
Degree of Operating = Percentage change in profit
Leverage Percentage change in output
* = Contribution MarginEBIT
= Sales Total Variable Cost
Sales Total Variable Cost Total
Fixed Costs
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y DOL is the counterpart of the concept elasticity in basiceconomics.
y
It measures the responsiveness of profits to a change inthe level of output.
y Since fixed costs does not change with output, DOL willhave values at different volumes of output as follows:
y
(a) positive above the break-even sales volumey (b) negative below the break-even sales volume and;
y (c) zero at zero sales volume
y DOL decreases as the volume of output increases.
Operating Leverage
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Operating Leveragey Illustrative Example:y T wo companies producing identical products for the same
markets have the following costs and sales levels:
ABC Co. XYZ Co.
Total Variable Costs (P) 500,000 1,200,000
Total Fixed Costs (P) 1,000,000 300,000
Total Sales Volume (units) 10,000 10,000
Total Sales (P) 2,000,000 2,000,000
The management of the two companies would want todetermine their respective degrees of leverage at these saleslevel