Degree of Operating Leverage

What is a Degree of Operating Leverage (DOL)?

Degree of Operating Leverage measures the sensitivity of company’s operating income with changes in sales; a higher DOL implies higher proportion of fixed cost in the business operations whereas lower DOL implies lower fixed cost investment in running the business.

Degree of Operating Leverage Formula

The formula is used to determine the impact of a change in a company’s sales on the operating income of that company.

The formula of Degree of Operating Leverage (DOL) is derived by dividing the percentage change in the EBIT by the percentage change in the sales, and it is represented as,

Formula = Percentage change in EBIT / Percentage change in sales

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Source: Degree of Operating Leverage (wallstreetmojo.com)

Conversely, the formula for DOL can also be derived by dividing the contribution marginContribution MarginThe contribution margin is a metric that shows how much a company's net sales contribute to fixed expenses and net profit after covering the variable expenses. As a result, we deduct the total variable expenses from the net sales when computing the contribution.read more by the EBIT of the company, which is mathematically represented as,

Formula = Contribution margin / EBIT

It can be further expanded as shown below,

Degree of Operating Leverage Formula = (Sales – Variable cost) / (Sales – Fixed cost – Variable cost)

Explanation

The formula can be derived by using the following three steps:

  1. Firstly, determine the operating income vs. EBITOperating Income Vs. EBITEBIT refers to the business's earnings during a period without considering the interest expense and the tax expense. In contrast, operating income is the income earned by a business organization from its principal revenue-generating activities, not considering non-operating income and expenses.read more during the current year and the previous year. Now, compute the percentage change in EBIT initially by deducting the EBIT of the previous year from that of the current year and then dividing the result by the EBIT of the previous year as shown below,


    Percentage change in EBIT = (EBIT current year – EBIT previous year) / EBIT previous year * 100%

  2. Next, determine the sales during the current year and the previous year. Now, compute the percentage change in sales initially by deducting the sales of the previous year from that of the current year and then dividing the result by the sales of the previous year as shown below,


    Percentage change in sales = (Sales current year – Sales previous year) / Sales previous year * 100%

  3. Finally, the formula can be calculated by dividing the value in Step 1 by that of Step 2 as above.

Examples

Let’s see some simple to advanced examples to understand it better.

You can download this Degree of Operating Leverage Formula Excel Template here – Degree of Operating Leverage Formula Excel Template

Example #1

Let us take the example of Company A, which has clocked sales of $800,000 in year one, which further increased to $1,000,000 in year two. In year one, the operating expenses of the company stood at $450,000, while in year two, the same went up to $550,000. Determine the DOL for Company A.

Use the following data for the calculation of the Degree of Operating Leverage.

ParticularsYear 1Year 2
Sales$8,00,000$10,00,000
Operating Expense$4,50,000$5,50,000

EBIT in year 1

DOL EXAMPLE 1.2
  • EBIT in year 1 = Sales in year 1 – Operating expense in year 1
  • = $800,000 – $450,000
  • = $350,000

EBIT in Year 2

DOL EXAMPLE 1.3
  • EBIT in year 2 = Sales in year 2 – Operating expense in year 2
  • = $1,000,000 – $550,000
  • = $450,000

Change in EBIT

DOL EXAMPLE 1.4
  • Change in EBIT = EBIT in year 2 – EBIT in year 1
  • = $450,000 – $350,000
  • = $100,000

Percentage Change in EBIT

DOL EXAMPLE 1.5
  • Percentage change in EBIT = Change in EBIT / EBIT in year 1 * 100%
  • = $100,000 / $350,000 * 100%
  • = 28.57%

Change in Sales

DOL EXAMPLE 1.6
  • Change in sales = Sales in year 2 – Sales in year 1
  • = $1,000,000 – $800,000
  • = $200,000

Percentage Change in Sales

DOL EXAMPLE 1.7
  • Percentage change in sales = Change in sales / Sales in year 1 * 100%
  • = $200,000 / $800,000 * 100%
  • = 25.00%

Calculation of Degree of Operating Leverage will be –

DOL EXAMPLE 1.8

Now, DOL Formula = Percentage change in EBIT / Percentage change in sales

  • DOL Formula= 28.57% / 25.00%
  • = 1.14

Therefore, the DOL of Company A is 1.14.

Example #2

Let us take the example of another Company B, which is in the business of chocolate manufacturing and, in the current year, has achieved a sales volume of 18,000 pieces with an average sales price of $50 per piece. The overall cost structure of the company is such that the fixed cost is $100,000, while the variable cost is $25 per piece. Calculate Degree of Operating Leverage for Company B.

Use the following data for the calculation of the Degree of Operating Leverage.

Sales Volume18000
Average Sales Price Per Piece$50
Variable Cost Per Piece$25
Fixed Cost$1,00,000
Sales$9,00,000
Variable Cost$4,50,000

Sales = Sales volume * Average sales price per piece

  • = 18,000 * $50
  • = $900,000

Variable cost = Sales volume * Variable cost per piece

  • = 18,000 * $25
  • = $450,000

Contribution Margin

DOL example 2.2

Contribution margin = Sales – Variable cost

  • = $900,000 – $450,000
  • = $450,000

EBIT

DOL example 2.3

EBIT = Sales – Variable cost – Fixed cost

  • = $900,000 – $450,000 – $100,000
  • = $350,000

Calculation will be as follows –

DOL example 2.4

Now, DOL Formula = Contribution margin / EBIT

  • DOL Formula = $450,000 / $350,000
DOL example 2.5
  • = 1.29

Therefore, the DOL of Company B is 1.29.

Degree of Operating Leverage Calculator

You can use the following Degree of Operating Leverage Calculator.

Percentage Change in EBIT
Percentage Change in Sales
DOL Formula
 

DOL Formula =
Percentage Change in EBIT
=
Percentage Change in Sales
0
= 0
0

Relevance and Uses

It is important to understand the concept of DOL formula because it helps a company to appreciate the effects of operating leverage on the probable earnings of the company. It is a key ratio for a company to determine a suitable level of operating leverage that can be utilized to secure the maximum benefit out of the operating income of a company.

If a company has high operating leverage, then it means that a large proportion of its overall cost structure is due to fixed costs. Such a company will enjoy huge changes in profits with a relatively smaller increase in sales. On the other hand, if a company has low operating leverage, then it means that variable costs contribute a large proportion of its overall cost structureOverall Cost StructureCost Structure refers to those costs or expenses (fixed as well as variable costs) which businesses will incur or will have to incur to produce the desired objective of the business; such costs include the cost of purchasing the raw material to the cost of packaging the finished products.read more. Such a company does not need to increase sales per se to cover its lower fixed costs, but it earns a smaller profit on each incremental sale.

Nevertheless, a company with high operating leverageOperating LeverageOperating Leverage is an accounting metric that helps the analyst in analyzing how a company’s operations are related to the company’s revenues. The ratio gives details about how much of a revenue increase will the company have with a specific percentage of sales increase – which puts the predictability of sales into the forefront.read more should always keep in mind that vis-à-vis a company with low operating leverage, it is more vulnerable to poor corporate decisions and other variables that may result in a significant decrease in income.

Recommended Articles

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