Breakeven analysis permits the financial manager to determine the quantity of output or the level of sales that will result in an EBIT level of zero. This means the firm has neither a profit nor a loss before any tax considerations. The effect of price changes, cost structure changes, or volume changes on profits (EBIT) can be studied. To make the technique operational, it is necessary that the firm's costs be classified as fixed or variable. Not all costs fit neatly info one of these two categories. Over short planning horizons, though, the preponderance of costs can be assigned to either the fixed or variable classification. Once the cost structure has been identified, the breakeven point can be found by use of (1) trial-and -error analysis, (2) contribution-margin analysis, or (3) algebraic analysis.

Operating leverage is the responsiveness of the firm's EBIT to changes in sales revenues. It arises from the firm's use of fixed operating costs. When fixed operating costs are present in the company's cost structure, changes in sales are magnified into even greater changes in EBIT. The firm's degree of operating leverage from a base sales level is the percentage change in EBIT divided by the percentage change in sales. All types of leverage are two-edged swords. When sales decrease by some percentage, the negative impact upon EBIT will be even larger.

A firm employs financial leverage when it finances a portion of its assets with securities bearing a fixed rate of return. The presence of debt and/or preferred stock in the company's financial structure means that if is using financial leverage. When financial leverage is used, changes in EBIT translate into larger changes in earnings per share. The concept of the degree of financial leverage dwells on the sensitivity of earnings per share to changes in EBIT. The DFL from a base EBIT level is defined as the percentage change in earnings per share divided by the percentage change in EBIT. All other things equal, the more fixed-charge securities the firm employs in its financial structure, and financial leverage is used, the firm's shareholders endure negative changes in falls, and financial leverage is used, the firm's shareholders endure negative changes in earnings per share that are larger than the relative decline in EBIT. Again, leverage is a two-edged sword.

Firms use operating and financial leverage in various degrees. The joint use of operating and financial leverage can be measured by computing the degree of combined leverage, defined as the percentage change in earnings per share divided by the percentage change in sales. This measure allows the financial manager to ascertain the effect on total leverage caused by adding financial leverage on top of operating leverage. Effects can be dramatic, because the degree of combined leverage is the product of the degrees of operating and financial leverage. Table 13.10 10 summarizes the salient concepts and calculation formats discussed in this chapter.