## 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

$$

D

O

THE

=

%

switch

E

B

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%

change in sales

or:

E

B

I

T

=

profit before income and taxes

begin {aligned} & DOL = frac {% text {variation in EBIT} {% text {variation in sales}} & textbf {where:} & EBIT = text {profit before profit and taxes} end {aligned}

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

=

change in operating profit

changes in sales

text {Degree of operating leverage} = frac { text {change in operating profit}} { text {change in sales}}

Degree of operational leverage=changes in saleschange in operating profit

$$

Degree of operational leverage

=

contribution margin

operating result

text {Degree of operating leverage} = frac { text {contribution margin}} { text {operating result}}

Degree of operational leverage=operating resultcontribution margin

$$

Degree of operational leverage

=

sales – variable costs

sales – variable costs – fixed costs

text {Degree of operating leverage} = frac { text {sales – variable costs}} { text {sales – variable costs – fixed costs}}

Degree of operational leverage=sales – variable costs – fixed costssales – variable costs

$$

Degree of operational leverage

=

percentage of contribution margin

operating margin

text {Degree of operating leverage} = frac { text {percentage of contribution margin}} { text {operating margin}}

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

E

B

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=

$

5

0

0

,

0

0

0

–

$

1

5

0

,

0

0

0

=

$

3

5

0

,

0

0

0

Second year

E

B

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$

6

0

0

,

0

0

0

–

$

1

7

5

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0

0

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=

$

4

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0

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0

begin {aligned} & text {An one} EBIT = $ 500,000 – $ 150,000 = $ 350,000 & text {Year two} EBIT = $ 600,000 – $ 175,000 = $ 425,000 end {aligned}

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

E

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(

$

4

2

5

,

0

0

0

??

$

3

5

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,

0

0

0

)

–

1

=

2

1

.

4

3

%

%

change in sales

=

(

$

6

0

0

,

0

0

0

??

$

5

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0

,

0

0

0

)

–

1

=

2

0

%

begin {aligned} % text {change in} EBIT & = ( $ 425,000 div $ 350,000) – 1 & = 21.43 % % text {change in sales} & = ( $ 600,000 div $ 500,000) -1 & = 20 % end {aligned}

% 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:

$$

D

O

THE

=

%

change in operating profit

%

change in sales

=

2

1

.

4

3

%

2

0

%

=

1

.

0

7

1

4

begin {aligned} DOL & = frac {% text {change in operating profit}} {% text {change in sales}} & = frac {21.43 %} {20 % } & = 1.0714 end {aligned}

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:

$$

D

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%

switch

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change in sales

=

D

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×

D

F

THE

DCL = frac {% text {change in} EPS} {% text {change in sales}} = DOL times DFL

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?”)