Operating Leverage - Explained in hindi - YouTube

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Namaskar my name is Mukul and welcome to Asset Yogi.

In this video we are going to discuss about Operating Leverage.

This video is a part of a series in which we are discussing Leverage,

I had discussed the whole concept of Leverage in the previous video,

if you have not seen that video,

then I will recommend that you should watch

that video first before watching this video,

So that at least you should be clear about the concept of Leverage.

In this video we will go a little further

and understand the calculation of Operating Leverage and it's Formula.

We will see that if sales increase by some percentage,

let's say it increases by 10 percent.

then how can our profit increase by 20%?

So you must watch this video till the last.

Let's go straight to the blackboard.

Let's do a quick recap of the last video.

when we talk about the Science concept of Leverage,

Suppose we want to lift this weight,

for that we put its support here, then we call this point the Fulcrum point.

If we apply force here, then we can lift this weight.

So, this lever denotes the l, I have written in Small alphabet,

if the difference from Force to Fulcrum point is less,

So you will have to apply more force and you will be able to lift less weight.

This means that this lever is called as leverage.

If the leverage is low then you have to put more effort and you will get less output.

If we shift this fulcrum point here as we can see in this second figure.

So our distance has increased,

this bigger L here increased your leverage In this case So in this case,

you will have to apply less force,

you will be able to lift this weight easily.

And you may be able to lift a little more weight too.

So what happens from higher level, your effort is less and you get more output.

Then when we talk about Operating leverage in Finance,

what is this leverage in that and what is a Lever?

In that our leverage is Fixed Cost.

What is the impact on the business due to Fixed cost,

that if sales increase then how many times profit will increase,

we get to know that from Operating leverage.

Let's try to understand this with an example.

I also talked to you in the last video about High Operating Leverage Companies

we took the example of Airlines

that fixed cost is very high in the Airlines Industry

like aircraft's Lease or if you have bought aircraft then it is a fixed cost for that company

Hangars have to be rented wherever these aircraft are parked.

you have to pay it's rent.

Also, have to pay the Insurance then this fixed cost becomes quite high.

what is Variable cost?

Jet fuel has to be paid whenever the Plane fly

You will also incur runway charges only when the plane is in use

or the more sales are made, the more

your runway charges will increase and the more jet fuel is consumed.

As your incremental sales increase, your fixed costs are going to remain the same

but your profits can be double or even triple.

Let's say if the sales are double, then your profits can be four time.

This is the advantage of an Operating leverage company

but it also has a disadvantage that the company can default as quickly

if the economy is bad or the market conditions are bad.

Now we will understand it by calculation.

Now let's talk about a Low Operating Leverage company.

So suppose there is a Consulting or Service industry,

In that your fixed cost is very less,

what can be the fixed cost?

like rent your rent will be fixed of office,

utility bills are electricity or water bills

those are relatively low, if I talk about overall cost

The variable cost is very high in these and that is the Salary of the employees,

so the more work comes, the more they will be hired.

And if there is no work in the consulting or service industry,

then those people also lay off very quickly.

Let us now understand its calculation and see what is the impact in real.

If we talk about an income statement, then suppose there is a Shoe manufacturing company

and its turnover in crores is now 200 crores of the latest year.

The revenue of Sales has come to 200 crores in the latest year.

Out of this, what will we do? we will minus Variable cost.

Let's assume that It's Variable cost was 40 crores within this year.

Now look at Sales and Variable Cost

The more the sales increase, the more the variable cost will increase.

If this company is making thousand shoes, I am taking an example,

Suppose One factory is making thousand shoes,

maybe they have multiple factories and multiple distribution centres.

If they make a thousand shoes,

then the sales of these thousand shoes

they will get a variable cost of thousand shoes only,

If there is sales of 2 thousand shoes

then there will be a cost of 2 thousand shoes

The more sales increase, the more the variable cost will go on increasing

in the same proportion.

After that, if you minus variable cost out of Sales,

then you get the contribution.

we call that figure Contribution.

200 crores minus 40 crores = 160 crores.

Then we calculate its fixed cost

whatever is the entire setting cost of the factory

or whatever their overall cost is fixed cost

rent or any other cost.

It comes let's say 80 crores

and then we minus it from contribution then we get operating profit.

This is called Earning before Interest and Taxes.

If you minus 80 out of 160, then 80 crores are left.

Out of that, you minus interest, whatever loan they have taken,

the company has to pay some interest annually on it, it is 40 crores .

If you minus that then you get Profit before Taxes.

So, 80 - 40 is 40 crore.

On this let's assume the Tax is 30%.

So, 30% of 40 is 12 crores

if you minus this then you get Profit after Taxes,

that has becomes 28 crores.

Now we want to see how much difference it is going to make

to our operating profit if our sales grow by maybe 20%.

So what we want to study,

is we want to see the effect of fixed cost

on what difference it makes to operating profit.

We want to study the relationship between this two,

the contribution and operating profit.

and this is what we call the Degree of Operating Leverage.

Now I will also tell you the formula of Degree of Operating Leverage,

first let us see it practically once

So, their sales in year 2 increase by 20%,

so here it increases by 40 crores.

It is not 40%, it has become 40 crores absolutely, it has increased by 20%.

And in percentage, I write here Delta.

So, it has increased by 20%.

The variable cost we said also increases in the same promotion,

if two thousand shoes are sold, then two thousand shoes will have to be made.

Not two thousand shoes, but here the variable cost is 40 crores,

we have to increase that by 20 percent.

So, it is 48 crores and it has also become plus 20%.

If we minus 48 out of 240 then it becomes 192.

The difference between 160 and 192 is also 20%.

Now pay attention to the fixed cost, it is going to be Same,

80 crores will remain 80 crores.

Variable cost, We are making more shoes in the same factory.

so our fixed cost is same.

Now EBIT i.e. Earning before Interest and Taxes

has become 112 crores, out of 192 we deducted 80,

So the EBIT, how much does it increased or decreased,

It's 80 of 80, it's zero

and this is plus 40%

after that your interest will be the same.

It's the same factory, so the interest will be the same of 40 crores.

Then if you minus this out of 112, then your Profit before Tax has come to 72 crores.

then your 30% Tax will be 21.6 crores.

So, Profit after Tax is 50.4 crores.

Now what we want to calculate, we want to calculate Degree of Operating Leverage.

what is its formula?

%change in EBIT

that means, we are talking about EBIT and contribution.

We basically have to establish their relationship,

so you will divide this plus 40% by %change in contribution.

%change in contribution it is your plus 20%.

Now see why I have written Sales here instead of contribution.

You can also take sales

because the contribution is directly proportional to sales.

So sales are increasing by 20% so contribution is also increasing by 20%.

We take Sales because the figure of contribution

is not easily available to us from the balance sheet.

No company tells you the difference between variable cost and fixed cost.

It does not tell you the Bifurcation.

That's why if you take the sales, it can be calculated quite easily,

you can remove this contribution and can take %change in sales

We remove this contribution here and we will consider this one plus 20%.

So, here we did Delta EBIT Divided by Delta Sales

So, it is 40% divided by 20%.

we got here 2, so our Degree of Operating Leverage is 2.

What does it mean?

that if our sales increase then our EBIT i.e. operating profit will be double.

If sales increase by 30%, then our operating profit,

Here I write Delta EBIT and this is Delta Sales

If our sales increased by 30 percent, then our delta EBIT

operating profit would increase by 60 percent.

If this company wants to increase its sales, its operating profit will be double.

If suppose they want to increase their operating profit by 60%,

then they have to increase the sales by 30%.

you can see it this way.

Now look, this is our main formula to calculate and it is a very practical formula.

But sometimes you can also use another formula

and this formula is Degree of Operating Leverage = Contribution divided by EBIT.

Simply, with this figure of contribution, you can divide 160 by 80.

Now look, you can calculate this, but you do not get this figure of contribution easily,

because as I said earlier that the company does not tell you

the Variable cost and Fixed cost in the balance sheet

That's why this is a practical formula, you can use it.

But if you have a definite Variable cost and Fixed cost and it's bifurcation.

So if you get this information then you can calculate

the degree of operating leverage with this formula as well

also, it is easy to calculate.

So, we understood the formula

and we saw that if this percentage increases

then our operating profit gets doubled.

Now let us see what will happen if the sales that we have are reduced.

So let's just say our Sales is reduced by 20 percent, let's say it's 160 crores.

So here the delta is -20%.

then our variable cost will also be -20%.

Our contribution will also be -20%.

our fixed cost is going to be the same, so the difference will be zero.

EBIT is our operating profit it will be -40%.

48 crore, How much is the difference between these two it's -32 crores.

So, this 32 crore is 40% of 80 crore

Here it is -40%

After that, your interest is going to be the same, profit before tax, 40 out of 48,

you have remained only 8 crores.

30 percent tax levied 2.4 crores, so your Profit after Tax is 5.6 crores.

All if we again calculate the Degree of Operating Leverage,

We will take the %change in EBIT.

Divided buy we will do delta sales so it becomes -40%.

divided by -20%

-40% and -20%

so, it's 2 again.

This way you can see that the effect is on both sides

If sales were our plus 20%, then our operating profit

would have been plus 40% i.e. it was doubled.

If sales make us -20% then our operating profit goes up to -40%.

it's a double edged sword.

Let us now apply this analysis to a company with operating leverage.

Even if we talk about Airlines,

we said that if our Fixed costs are more, then our profit increases more rapidly

as soon as the sales increase even a little.

What happens in this case when the market is doing well

then you can do better sales then your profits grow twice as fast.

But if there is recession in the market,

then you are at high operational risk.

As we have seen if your Sales are -20% then your profit is -40%.

That means if your sales is -50% then the profit will be –100%,

the entire profit will be eroded.

That's why it becomes very difficult for a high operating leverage company

to perform under Recession.

But when we talk about low operating leverage company

Talking about industries like Consulting

if business goes default

Businesses can deduct it's Variable Costs more quickly.

If the business is default, then they are layoffs for employees,

this is the biggest cost of salaries,

the company reduces it and their fixed cost is very less.

That's why Low operating leverage company

can easily survive under bad market conditions.

So, this is the effect of your operating leverage,

now in the next video, we will understand the Degree of Finance Leverage.

The interest means that whatever loan you have taken or paying the interest,

what is its effect on your sales and profit?

That's all for this video.

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