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 concept of DOL revolves around the proportion of fixed costs and variable costs in the overall cost structure of a company.
• A company with a higher proportion of fixed costs has a higher DOL as compared to a company with a higher proportion of variable costs.
• If in case the DOL is high, then the earnings before interest and taxesEarnings Before Interest And TaxesEarnings before interest and tax (EBIT) refers to the company's operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization's profit from business operations while excluding all taxes and costs of capital.read more (EBIT) is more sensitive to the percentage change in sales while all other variables remaining the same, and vice versa.

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,

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For eg:
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,

It can be further expanded as shown below,

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

Explanation

Examples

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

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 expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more 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.

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

EBIT in year 1

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

EBIT in Year 2

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

Change in EBIT

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

Percentage Change in EBIT

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

Change in Sales

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

Percentage Change in Sales

• 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 –

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 Volume	18000
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

Contribution margin = Sales – Variable cost

• = $900,000 – $450,000
• = $450,000

EBIT

EBIT = Sales – Variable cost – Fixed cost

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

Calculation will be as follows –

Now, DOL Formula = Contribution margin / EBIT

• DOL Formula = $450,000 / $350,000

• = 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.

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 costsFixed CostsFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more. 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

This article has been a guide to the Degree of Operating Leverage (DOL) Formula. Here we discuss how to calculate the Degree of Operating Leverage using practical examples along with downloadable excel templates. You may learn more about Financial Analysis from the following articles –

• Degree of Financial Leverage Formula
• Operating Leverage vs. Financial leverage
• Leveraged Finance