What is the degree of operating leverage?
The degree of operating leverage (DOL) is a measure used to assess the change in a company’s operating income after a percentage change in its sales. The operating leverage of a business consists of evaluating fixed costs and variable costs against sales. Fixed costs do not change with production levels; therefore, variable costs must be included in the calculation.
Key points to remember:
- The DOL is a measure that reflects the change in a company’s operating income after a percentage change in its sales.
- DOL reflects the operational risk a business faces due to its fixed and variable cost structure.
- A high degree of operating leverage indicates that a business is likely to experience profit volatility with a change in sales because it has a large proportion of fixed costs in its total costs.
- A low degree of operating leverage implies that a business has a high proportion of variable costs and that the business does not have to significantly increase sales to cover its fixed costs.
Understand the degree of operational leverage
The degree of operating leverage quantifies the operating risk of a business that results from the fixed and variable cost structure. Fixed costs do not change with production, so a business cannot use them to adjust operating costs to affect sales. Therefore, the operational risk increases with an increase in the proportion of fixed costs to variable costs.
A company with a strong operating leverage has high fixed costs compared to its variable costs. If the degree of operating leverage is high, earnings before interest and taxes (EBIT) will experience volatility relative to a percentage change in sales, everything else remaining the same, and vice versa. There are a few formulas you can use to calculate the degree of leverage in operating a business.
Operating leverage and profit
The DOL ratio helps analysts determine the impact of any change in sales on company profits. Operating leverage measures the fixed amount of a business 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 substantial increase in sales can lead to disproportionate changes in profits.
Since companies with higher operating leverage do not increase their expenses proportionately as they increase their sales, they may generate more operating revenue than other companies. However, companies with high operating leverage face more risk if sales fall. Therefore, they are also more affected by poor management decisions and other factors that can lead to loss of income.
A business with low operating leverage has a high proportion of variable costs, which means it potentially realizes a lower gross margin on each sale, but doesn’t run as much of a risk of covering fixed costs when it goes down. Sales.
Most fixed costs occur regardless of the volume of sales. However, as long as a business makes a substantial profit from each sale and maintains an adequate sales volume, fixed costs are covered and profits are made.
Calculation of the Degree of Operational Leverage
The primary formula used to calculate the degree of operating leverage divides the percent change in EBIT by the percent change in sales. For example, XYZ Company’s EBIT increased 8.58% from 2018 to 2019, and its sales increased 6.04% during the same period. The degree of operational leverage is shown in the following table:
|Company XYZ (in millions)|
|Degree of operating leverage||1.4206|
The degree of operating leverage can also be calculated by subtracting variable costs from sales and dividing that number by sales minus variable costs and fixed costs. For example, for the fiscal year ended 2019, Company A had revenue of $ 55.63 billion, fixed costs of $ 11.28 billion, and variable costs of $ 30 billion. Company B had sales of $ 29.32 billion, fixed costs of $ 5.47 billion, and variable costs of $ 16.38 billion.
Company A’s operating leverage is ($ 55.63 billion – $ 30 billion) / ($ 55.63 billion – $ 30 billion – $ 11.28 billion) = 1.78 . Company B’s operating leverage is ($ 29.32 billion – $ 16.38 billion) / ($ 29.32 billion – $ 16.38 billion – $ 5.47 billion) = 1.73. If both companies register a 20% increase in sales, Company A’s profits increase by 35.6% and Company B’s profits increase by 34.6%.
|Company A ($ millions)||Company B ($ millions)|
|Variable costs (CV)||29,993||16,376|
|Fixed costs (CF)||11 281||5 473|
|Sales – VC||25 639||12 942|
|Sales – VC – FC||14 358||7,469|
|Degree of operating leverage||1.79||1.73|