Operating leverage in times of crisis

Operating leverage in times of crisis

We could say that the most difficult stage of the economic crisis is past and that all economies are starting to grow, but this economic recovery is still weak. This means that the high unemployment rate will continue for now as well as most of the companies still have much of their productive capacity that is not being used, generating that employers do not want to invest for the moment.

We must seize on these circumstances, with continuous innovation in our company and apply new technologies to use more of our machinery and equipment in order to have a sustained growth of our business. To find out which is the degree of use of our machines, use the operating leverage method.

Operating leverage is the degree of percentage change in operating income for each percentage change in sales, this system can know which is the level of use we give to our fixed costs (machinery and equipment)

Terminology
:
Net Sales VN = VN = P x Q
P = price
Q = Quantity of goods or services produced

Total Cost TC = CT = CF + CV
CF = Fixed Cost
VC = Variable Cost
V = unit variable cost = VC / Q we have:

Case 1

P = $ 20
Q = 2000 TR = $ 2,000 x 20 = $ 40,000

CF = 1000 hp = 20000 CT = 1000 (CF) +20000 (CV) = $ 21,000

Then: IT (total income)    =     40,000
(Less) Ct (Cost of sales) =     21,000 (CF + CV)
Operating income           =     19.000                            

GAO (degree of operating leverage) = Q (PV) / Q (PV) – CF

V = CV / QV = 20000/2000) then V = 10

Replacing we have:

GAO (degree of operating leverage) = Q (PV) / Q (PV) – CF

GAO = 2000 (20 – 10) / 2000 (20 to 10) – 1000

GAO = 1.05

The above means that every time we increase our income (Product of an increase in our production) at a rate of l% operating income was affected in the same proportion, this does not give us anything important because we are using all the installed capacity of the company as growth in our production does not generate new profits above those already established, unless the company makes further investment in machinery and equipment to replace part of its fixed cost variable cost. This improved technology will also negotiate with suppliers taking advantage of the offers to improve our machinery and technology for our company as cheaply as possible, understanding that the lowest price negotiation means finding better technology for our business without neglecting the quality of what we buy.

Case 2

P = $ 20
Q = 2.000 TR = $ 2,000 x 20 = $ 40,000

CV = CF = 15.000 20.000 20,.000 CT = (CV) + 15.000 (CF) = $ 35,000

Then: IT (total income)    = 40,000
(Less) CT (Cost of sales) = 35.000
Operating income            =    5,000

We see that our operating income in this case is extremely low and that the total costs of sale (35000) 87.5% of total sales (35,000 / 40,000), is very high as previously estimated for companies is between 35 to 40 %, we are using little of our productive capacity.

GAO (degree of operating leverage) = Q (PV) / Q (PV) – CF

V = CV / QV = 20000/2000) then V = 10

Replacing we have:

GAO = 2.000 (20 – 10) / 2,000 (20 – 10) – 15,000

DOL = 20,000 / 5,000

GAO = 4

With a 4 GAO income we have that if 1% increase in the operating income increased 4%, in other words we will have a more useful product for a better use of our machinery and equipment, therefore the company increased its production which will most useful.

Lucio Ayala

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