Degree Of Operating Leverage - DOL

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What is a 'Degree Of Operating Leverage - DOL'

The degree of operating leverage (DOL) is a leverage ratio that summarizes the effect a particular amount of operating leverage has on a company's earnings before interest and taxes (EBIT) over a period of time. Operating leverage involves using a large proportion of fixed costs to variable costs in the operations of the company. The formula is as follows:

Degree Of Operating Leverage (DOL)

BREAKING DOWN 'Degree Of Operating Leverage - DOL'

The higher the degree of operating leverage, the more volatile and unpredictable the EBIT figure is relative to a given change in sales, assuming all other variables remain constant. The DOL ratio is useful as it helps analysts determine the effects of a given level of operating leverage on the earnings potential of a company. This ratio can also be used to help company decision-makers determine the most appropriate level of operating leverage to maximize the company's EBIT.

Degree of Operating Leverage Formula

The formula for the DOL takes into account two variables. They are:

1) The percentage change in EBIT from time period one to time period two

2) The percentage change in sales from time period one to time period two

The formula is then, DOL = % change in EBIT / % change in sales

EBIT can be calculated by taking the sales revenue and subtracting the operating expenses.

Example Calculation

Assume Company X has $500,000 in sales in year one and $600,000 in sales in year two. For year one, the company's operating expenses were $150,000, while in year two, the operating expenses were $175,000. To calculate the DOL, the EBIT for each year must first be calculated. In this example, the EBIT values are:

Year one EBIT = $500,000 - $150,000 = $350,000

Year two EBIT = $600,000 - $175,000 = $425,000

Next, the percentage change in the EBIT values and the percentage change in the sales figures are calculated as:

% change in EBIT = $425,000 / $350,000 - 1 = 21.43%

% change in sales = $600,000 / $500,000 -1 = 20%

Lastly, the DOL ratio is calculated as:

DOL = 21.43% / 20% = 107.14%

Net operating income is the income remaining after fixed-cost payments are made by a company, irrespective of sales. If the DOL of a company is high, this means a relatively small increase in sales can have a large effect on net operating income. Calculating DOL can help in decision-making, which may prevent large losses to a company based on smaller changes in sales.