What is the degree of operational leverage (DOL)?
The degree of operating leverage (DOL) is a multiple that measures how much a company’s operating profit will change in response to a change in sales. Firms with a high proportion of fixed costs (or costs that do not change with production) to variable costs (costs that change with volume of production) have higher levels of operating leverage.
The DOL ratio helps analysts determine the impact of any change in sales on the profit or profit of the company.
Formula and calculation of the degree of operating leverage
DOTHE=% change in sales% switch EBITor:EBIT=profit before income and taxes
There are several alternative ways to calculate DOL, each based on the main formula given above:
Degree of operational leverage=changes in saleschange in operating profit
Degree of operational leverage=operating resultcontribution margin
Degree of operational leverage=sales – variable costs – fixed costssales – variable costs
Degree of operational leverage=operating marginpercentage of contribution margin
Key points to remember
- The degree of operating leverage measures how much a company’s operating profit changes in response to a change in sales.
- The DOL ratio helps analysts determine the impact of any change in sales on company profits.
- A company with high operating leverage has a large proportion of fixed costs, which means that a large increase in sales can lead to disproportionate changes in profits.
Operating leverage and DOL
What operating leverage can tell you
The higher the degree of operating leverage (DOL), the more sensitive a company’s earnings before interest and taxes (EBIT) are to changes in sales, assuming all other variables are held constant. The DOL ratio helps analysts determine the impact of any change in sales on company profits.
Operating leverage measures a company’s fixed costs as a percentage of its total costs. It is used to assess the break-even point of a business, that is, when sales are high enough to cover all costs and profit is zero. A company with high operating leverage has a large proportion of fixed costs, which means that a large increase in sales can lead to disproportionate changes in profits. A company with low operating leverage has a large proportion of variable costs, which means that it makes less profit on each sale, but does not have to increase sales as much to cover its lower fixed costs.
Example of using the degree of operating leverage
As a hypothetical example, assume that Company X has sales of $ 500,000 in year one and $ 600,000 in sales in year two. In the first year, the company’s operating expenses were $ 150,000, while in the second year, the operating expenses were $ 175,000.
First year EBIT=$500,000–$150,000=$350,000Second year EBIT=$600,000–$175,000=$425,000
Then the percent change in EBIT values and percent change in sales figures are calculated as follows:
% switch EBIT% change in sales=($425,000??$350,000)–1=21.43%=($600,000??$500,000)–1=20%
Finally, the DOL ratio is calculated as follows:
DOTHE=% change in sales% change in operating profit=20%21.43%=1.0714
The difference between the degree of operational leverage and the degree of combined leverage
The degree of combined leverage (DCL) extends the degree of operating leverage to get a more complete picture of a company’s ability to generate profit from sales. It multiplies the DOL by degrees of financial leverage (DFL) weighted by the ratio% change in earnings per share (EPS) to% change in sales:
DVSTHE=% change in sales% switch EPS=DOTHE×DFTHE
This ratio summarizes the effects of the combination of financial leverage and operations, and what effect this combination, or variations in this combination, has on the company’s earnings. Not all companies use both operating and financial leverage, but this formula can be used if they do. A business with a relatively high level of combined leverage is considered riskier than a business with less combined leverage because high leverage means more fixed costs for the business. (For related reading, see “How Do I Calculate the Degree of Operating Leverage?”)