Have you noticed a pattern: every time you increase your sales slightly, you experience an influx of profit disproportionate to sales?
If so, there is a chance that you have a high degree of operating leverage.
But what does it mean, and how do I calculate it?
The degree of operating leverage calculator is a tool for measuring this sensitivity. Calculating the degree of operating leverage (DOL) can help you gauge how a change in sales volume affects your operating income.
Degree of Operating Leverage Definition
The Degree of Operating Leverage measures the sensitivity of a company’s operating income to changes in sales. It assesses how fixed costs impact profitability.
High DOL indicates a higher proportion of fixed costs, amplifying the effect of sales fluctuations on earnings before interest and taxes (EBIT).
This is particularly important in sectors like manufacturing, where cost structures often include significant fixed costs.
Operating vs. Financial Leverage
Operating leverage focuses on a company’s cost structure, emphasizing the proportion of fixed versus variable costs. Higher fixed costs mean greater risk but also higher potential profit magnification.
In contrast, financial leverage involves using debt to fund operations.
High financial leverage increases financial risk due to interest obligations but can enhance earnings per share (EPS). Combined leverage considers both operating and financial leverage together.
Degree of Operating Leverage Formula
The formula for calculating the Degree of Operating Leverage is:
Degree of Operating Leverage = Percentage Change in EBIT / Percentage Change in SalesLet’s explain our formula variables:
- Percentage Change in EBIT: The percentual difference between two periods of EBIT (Earnings before interest and taxes)
- Percentage Change in Sales: The percentual difference in sales between two periods
You can calculate the difference between the two periods with the following formulas:
% Change in EBIT = (EBIT Current Period - EBIT Previous Period) / EBIT Previous Period% Change in Sales = (Sales Current Period - Sales Previous Period) / Sales Previous PeriodWe essentially calculate the difference between the two periods of sales and EBIT.
Another way to express the degree of operating leverage is:
Degree of Operating Leverage = Contribution Margin / Operating Income
Contribution Margin = Sales - Variable CostsUsing the contribution margin (sales minus variable costs) helps determine how much each sales dollar contributes to covering fixed costs and generating profit.
Example Calculation
Consider a manufacturing business with fixed costs of $100,000 and variable costs constituting 40% of sales. If sales increase from $200,000 to $250,000, we need to calculate the degree of operational leverage.
- Fixed costs: $100,000
- Sales previous period: $200,000
- Sales current period: $250,000
- Variable costs percentage: 40% of sales
First, let’s calculate our variable cost:
Initial Variable Costs = $200,000 * 0.4 = $80,000New Variable Costs = $250,000 * 0.4 = $100,000Then, calculate the EBIT before and after the sales change:
Initial EBIT = $200,000 - $80,000 - $100,000 = $20,000New EBIT = $250,000 - $100,000 - $100,000 = $50,000Now, we can use the DOL formula:
DOL = (($50,000 - $20,000) / $20,000) / (($250,000 - $200,000) / $200,000) =
DOL = 150% / 25% = 6A DOL of 6 means that for every 1% change in sales, the operating income will change by 6%.
Understanding Degree of Operating Leverage
The degree of Operating Leverage (DOL) assesses how operating income responds to changes in sales.
- High DOL: Indicates high fixed costs relative to variable costs, meaning profits are more sensitive to changes in sales. This can lead to higher earnings in good times but larger losses in bad times.
- Low DOL: Indicates low fixed costs relative to variable costs, meaning profits are less sensitive to changes in sales, leading to more stable, but potentially lower, profit margins.
But it is not as simple as looking purely at the DOL metric. When evaluating DOL value, we should also break it down further into EBIT and sales percentages.
Why? Negative EBIT and sales figures would still give you a positive high DOL, but this is a very bad situation for the business.
Going back to our calculation example, let’s reverse the data. This means that instead of growth, we actually decline as a business, and so our EBIT and sales are the following:
- EBIT: -150%
- Sales: -25%
Then our DOL = -150% / -25% = 6. It’s still six, except we are now experiencing a huge income decline.
So, higher leverage also raises financial risk. Companies with significant fixed costs may struggle to cover these expenses when sales drop.
The bottom line is that you should use DOL as a metric within the business context alongside other business metrics instead of a standalone value.