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


Related Articles
  1. Fundamental Analysis

    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. Professionals

    Degree of Total Leverage

    CFA Level 1 - Degree of Total Leverage. Learn how financial and operating leverage combine into total leverage. Provides an example showing how total leverage affects EPS.
  4. Professionals

    Financial Leverage

    This concept allows you to judge how risky a company is becoming
  5. Professionals

    Financial Leverage

    CFA Level 1 - Financial Leverage. Learn how the degree of financial leverage can affect EPS. Provides a definition and formula for the degree of financial leverage.
  6. Investing Basics

    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.
  7. Mutual Funds & ETFs

    DOL: WisdomTree International LargeCp Div ETF

    Learn more about the WisdomTree International LargeCap Dividend fund, an income-based international equities ETF that focuses heavily on the United Kingdom.
  8. Professionals

    Business Risk Ratios

    CFA Level 1 - Business Risk Ratios. Learn about the simple and complex method to calculating business risk. Includes the methodology and formulas for both approaches.
  9. Investing

    Introduction To Hedge Funds

    Find out how these highly leveraged funds operate.
  10. Investing

    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.
RELATED TERMS
  1. Degree Of Operating Leverage - ...

    A type of leverage ratio summarizing the effect a particular ...
  2. Operating Leverage

    Operating leverage is a measurement of the degree to which a ...
  3. Degree Of Combined Leverage - DCL

    A leverage ratio that summarizes the combined effect the degree ...
  4. Leverage

    1. The use of various financial instruments or borrowed capital, ...
  5. Degree Of Financial Leverage - ...

    A ratio that measures the sensitivity of a company’s earnings ...
  6. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company ...
RELATED FAQS
  1. What is the difference between degree of operating leverage and degree of financial ...

    Learn about the degree of financial leverage and the degree of operating leverage, what they measure, and the difference ... Read Answer >>
  2. How do I calculate the degree of operating leverage?

    Learn about the degree of operating leverage, what it measures and how to calculate a company's degree of operating leverage ... Read Answer >>
  3. What is the relationship between degree of operating leverage and profits?

    Find out why a company's degree of operating leverage is an important consideration when predicting future operating income ... Read Answer >>
  4. What is the difference between operating leverage and financial leverage?

    Discover the two equity valuation metrics, operating leverage and financial leverage, how they are similar and what differentiates ... Read Answer >>
  5. How can a firm bring down its operating leverage?

    Discover how to determine a company's operating leverage and how this metric can be helpful to analysts and investors when ... Read Answer >>
  6. What does a high degree of operating leverage indicate?

    Learn about the degree of operating leverage, how to calculate the ratio and what a high degree of operating leverage indicates ... Read Answer >>
Hot Definitions
  1. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
Trading Center