Leverage: A double-edged Sword ?

Have you ever wondered how the change in the percentage of profit/loss is more than the change in percent of revenue ?

First, we will understand the term leverage in business:

We won’t tell you the dictionary meaning of leverage but explain it in a short and simple manner.

Leverage in a company is observed due to the presence of Fixed Cost in a business.

Let us take an example to understand this sentence better.

If you are running a business of Tea Shop, overall the costs that you incur are the cost of the equipment (Cylinder) and the cost of producing tea (Tea Powder, sugar etc) which is all dependent on the amount of tea which you sell. Another cost not to neglect is the rent cost of the place where you have your business set up.

Out of these the cylinder, the tea powder, and all other costs which are included while producing tea is a variable cost i.e., the more tea you produce relatively higher cost you will incur on them.

But, the rent cost is not dependent on your output, i.e., if you produce 1000 tea cups or 10000 tea cups, the cost incurred in a particular period is the same (For example: rent = 10000 per year).

Now we will check what is the effect of leverage on actual numbers:

1.?????? Here, we can see that the percentage increase in the variable cost, Sales Quantity is not equal to the percentage increase in the profit.

2.?????? So the thumb rule is :

“Whenever there is a presence of fixed cost, there will be presence of leverage”.

But have you thought what will happen in the case of loss?

1.?????? Here we can see that, incase of loss (variable costs increased due to rise in the prices of commodity).

2.?????? The decrease in percentage of profit is more than decrease in the percentage of contribution [Contribution is basically Revenue (-) Variable Cost].

Conclusion:

·?????? Concluding the article we can see that when fixed cost is present even the leverage is present.

·?????? Due to leverage the change in profit/loss percentage is higher than the change in percentage of contribution.

·?????? In the end which tells us in the days of profit we are happier but in the days of we are saddest which helps us to conclude that leverage is a double-edged sword.

?Note :

Fixed cost is not fixed in the long term.