In one sentenceThe combined effect of operating and financial leverage, measuring by what percentage profit after financing cost changes if sales change by 1%.
Simply put
Operating leverage comes from fixed costs, and financial leverage from fixed financing cost. When they combine, the effect of any change in sales on profit is multiplied, both up and down.
Total leverage is calculated by multiplying the two leverages, or by dividing the contribution margin by profit after financing cost.
Worked example
A juice factory has a contribution margin of 400,000 SAR, fixed costs of 200,000 SAR, and financing cost of 100,000 SAR a year.
Profit before financing cost400,000 − 200,000 = 200,000 SAR
Profit after financing cost200,000 − 100,000 = 100,000 SAR
Operating × financial leverage(400,000 ÷ 200,000) × (200,000 ÷ 100,000) = 2 × 2
Total leverage = 400,000 ÷ 100,000: a 10% increase in sales raises profit by 40%4 times
Formula: Contribution margin ÷ profit after financing cost
Don't confuse it with
Operating leverageIt measures the effect of fixed costs alone on profit before financing cost.