Corporate Finance - Operating Leverage and its Effects on a Project's Expected Rate of Return

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


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