Operating leverage can be defined as the degree to which a company uses fixed costs in its operations. The higher the fixed costs as a percentage of total costs, the higher the company's operating leverage. For companies with high operating leverage, a small change in company revenues will result in a larger change in operating income since most costs are fixed rather than variable.

Degree of Leverage
The degree of leverage within a company can be calculated based on various metrics.

Some common metrics include:
1. Degree of operating leverage
2. Degree of financial leverage
3. Degree of total leverage

We will discuss operating leverage within this section.

Degree of Operating Leverage
Degree of operating leverage (DOL) is the percentage change in operating income, also known as EBIT, divided by the percentage change in sales. It is the measure of the sensitivity of EBIT to changes in sales as a result of changes in operating expenses. Degree of operating leverage is also commonly estimated using production output.

Formula 11.18

DOL = change in EBIT/EBIT  or  Q (P - V)
         change in sales/sales      Q(P - V)- F

A key shortcut to remember is that, if fixed costs of the project are equal to 0, the DOL is actually 1.

Example: Degree of Operating Leverage
Newco produces 140,000 units annually. With Project 1, the company's variable costs are $20 per unit, and its fixed costs total $2.4 million. With Project 2, the company's variable costs are $30 per unit, and its fixed costs total $2 million. Newco has the ability to see each unit at $50. Compute the DOL for Project 1 and Project 2.

Answer: Project 1 DOL = 140,000(50-20)/140,000(50-20) - 2,400,000 = 2.33

With Project 1, for every percentage increase in sales, the company's EBIT will increase 2.33 times; a 10% increase in sales will lead to a 23.3% increase in EBIT.

Project 2 DOL = 140,000(50-30)/140,000(50-30)-2,000,000 = 3.50

With Project 2, for every percentage increase in sales, the company's EBIT will increase 3.50 times; a 10% increase in sales will lead to a 35.0% increase in EBIT.



Financial Leverage

Related Articles
  1. Investing

    The Operating Leverage And DOL

    Operating leverage tells investors about the relationship between a company's fixed and variable costs. The higher a company's fixed costs in relation to its variable costs, the greater its operating ...
  2. Investing

    Operating Leverage Captures Relationships

    Find out how fixed and variable costs interact to shed new light on old companies.
  3. Taxes

    EBIT (Earnings Before Interest and Taxes)

    Earnings before interest and taxes, or EBIT, takes a company’s revenue, or earnings, and subtracts its cost of goods sold and operating expenses.
  4. Financial Advisor

    Understanding The Leverage Ratio

    Learn more on how the leverage ratio is used to calculate a company's ability to meet financial obligations and how changes in output will affect operating income.
  5. Investing

    Leverage: Is It Good for Your Portfolio?

    Discover the concept of financial leverage. Learn multiple ways to get leverage in your portfolio, and decide if leverage is a good idea for you.
  6. Personal Finance

    Borrowing Smart In A Debt-Filled World

    Leveraging your money can have many perks, but it's not always the smartest financial plan.
  7. Investing

    Explaining Leveraged Loans

    Leveraged loans are loans extended to companies or people who already have large amounts of debt.
  8. Trading

    How Much Leverage Is Right for You in Forex Trades

    It isn’t economics or global finance that trip up first-time forex traders. Instead, a basic lack of knowledge on how to use leverage is at the root of trading losses.
  9. Investing

    The Optimal Use Of Financial Leverage In A Corporate Capital Structure

    The amount of debt and equity that makes up a company's capital structure has many risk and return implications.
  10. Trading

    Forex Leverage: A Double-Edged Sword

    Find out how this flexible and customizable tool magnifies both gains and losses.
Trading Center