What is the degree of operating leverage (dol)?
The degree of operating leverage (dol) is a multiple that measures how much a company’s operating income will change in response to a change in sales. Companies with a large ratio of fixed costs to variable costs have higher levels of operating leverage.
The dol ratio helps analysts determine the impact of any change in sales on the company’s earnings.
The formula for the degree of operating leverage is:
Dol =% change in ebit% change in saleswhere: ebit = earnings before income and taxes \ begin {aligned} & dol = \ frac {\% \ text {change in} ebit} {\% \ text {change in sales}} \\ \ textbf {where:} \\ & ebit = \ text {earnings before income and taxes} \\ \ end {aligned} d or l = % of change in sales % change in e b i t where: e b i t = earnings before income and taxes
Calculate the degree of operating leverage
There are several alternative ways to calculate dol, each based on the primary formula given above:
Degree of operating leverage = change in operating incomechanges in sales \ text {degree of operating leverage} = \ frac {\ text {change in operating income}} {\ text {changes in sales}} degree of operating leverage = changes in sales change in operating income
Degree of operating leverage = contribution margin operating income \ text {degree of operating leverage} = \ frac {\ text {contribution margin}} {\ text {operating income}} degree of operating leverage = Operating income contribution margin
Degree of operating leverage = sales – variable costssales – variable costs – fixed costs \ text {degree of operating leverage} = \ frac {\ text {sales – variable costs}} {\ text {sales – variable costs – fixed costs}} degree operating leverage = sales – variable costs – fixed costs sales – variable costs
Degree of operating leverage = contribution margin percentage operating margin \ text {degree of operating leverage} = \ frac {\ text {percentage of contribution margin}} {\ text {operating margin}} degree of operating leverage = operating margin percentage of margin of contribution
2:27
operating leverage and dol
What does the degree of operating leverage tell you?
The higher the degree of operating leverage (dol), the more sensitive a company’s earnings before interest and taxes (ebit) will be to changes in sales, assuming all other variables remain constant. The dol ratio helps analysts determine what the impact of any change in sales will be on the company’s earnings.
Operating leverage measures a company’s fixed costs as a percentage of its total costs. It is used to evaluate the breakeven point of a business, which is where sales are high enough to pay 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 huge changes in profits. A company with low operating leverage has a large variable cost ratio, which means it makes a smaller profit on each sale, but doesn’t have to increase sales as much to cover its lower fixed costs.
Key findings
- The degree of operating leverage (dol) is a multiple that measures how much a company’s operating income will change in response to a change in sales.
- The dol ratio helps analysts determine the impact of any change in sales on the company’s earnings.
- A company with high operating leverage has a large proportion of fixed costs, which means that a large increase in sales can lead to huge changes in profits.
Example using degree of operating leverage
As a hypothetical example, let’s say company x has $ 500,000 in sales in the first year and $ 600,000 in sales in the second year. In the first year, the company’s operating expenses were $ 150,000, while in the second year, operating expenses were $ 175,000.
Year one ebit = $ 500,000− $ 150,000 = $ 350,000year two ebit = $ 600,000− $ 175,000 = $ 425,000 \ begin {aligned} & \ text {year one} ebit = \ $ 500,000 – \ $ 150,000 = \ $ 350,000 \\ & \ text {year two ebit} = \ $ 600,000 – \ $ 175,000 = \ $ 425,000 \\ \ end {aligned} year one and b i t = $ 5 0 0 , 0 0 0 – $ 1 5 0 , 0 0 0 = $ 3 5 0 , 0 0 0 year two e b it = $ 6 0 0 , 0 0 0 – $ 1 7 5 , 0 0 0 = $ 4 2 5 , 0 0 0
Then the percentage change in ebit values and the percentage change in sales figures are calculated as:
% change in ebit = ($ 425,000 ÷ $ 350,000) −1 = 21.43 %% change in sales = ($ 600,000 ÷ $ 500,000) −1 = 20% \ 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} % of change in e b i t % of change in sales = ( $ 4 2 5 , 0 0 0 ÷ $ 3 5 0 , 0 0 0 ) – 1 = 2 1. 4 3 % = ( $ 6 0 0 , 0 0 0 ÷ $ 5 0 0 , 0 0 0 ) – 1 = 2 0 %
Finally, the dol ratio is calculated as:
Dol =% change in operating income% change in sales = 21.43% 20% = 1.0714 \ begin {aligned} dol & = \ frac {\% \ text {change in operating income}} {\% \ text {change in sales }} \\ = \ frac {21.43 \%} {20 \%} \ \ \\ & = 1.0714 \ end {aligned} d or l = % of change in sales % change in revenues = 2 0 % 2 1 . 4 3 % = 1 . 0 7 1 4
The difference between the degree of operating leverage and the degree of combined leverage
The degree of combined leverage (dcl) expands the degree of operating leverage to get a more complete picture of a company’s ability to generate profit from sales. multiply dol by degrees of financial leverage (dfl) weighted by the ratio of the% change in earnings per share (eps) over the% change in sales:
Dcl =% change in eps% change in sales = dol × dfl dcl = \ frac {\% \ text {change in} eps} {\% \ text {change in sales}} = dol \ times dfl d c l = % of change in sales % change in e p s = d or l × d f l
This relationship summarizes the effects of combining financial and operating leverage, and what effect this combination, or variations in this combination, has on the corporation’s earnings. Not all corporations use operating and financial leverage, but this formula can be used if they do. a company with a relatively high level of combined leverage is considered riskier than a company with less combined leverage because high leverage means more fixed costs for the company. (For related reading, see “How do I calculate the degree of operating leverage?”)
