What Is the Degree of Operating Leverage?
The degree of operating leverage (DOL) is a measure used to evaluate how a company's operating income changes after a percentage change in its sales. A company's operating leverage involves assessing fixed costs and variable costs against sales. Fixed costs do not change depending on production levels; therefore, variable costs must be included in the calculation.
- The DOL is a measure that reflects the change in a company's operating income after a percentage change in its sales.
- The DOL reflects the operating risk a company faces as a result of the structure of its fixed and variable costs.
- A high degree of operating leverage indicates that a company is likely to experience volatility in its earnings with a change in its sales because it has a large proportion of fixed costs in its total costs.
- A low degree of operating leverage implies that a company has a high proportion of variable costs, and the company does not have to dramatically increase sales to cover its fixed costs.
Understanding the Degree of Operating Leverage
The degree of operating leverage quantifies a company’s operating risk that is a result of the structure of fixed and variable costs. Fixed costs do not change based on production, so a company cannot use them to adjust its operating costs to affect its sales. Therefore, operating risk rises with an increase in the proportion of fixed-to-variable costs.
A company with a high degree of operating leverage has high fixed costs relative to its variable costs. If the degree of operating leverage is high, the earnings before interest and taxes (EBIT) experiences volatility with respect to a percentage change in sales, all else remaining the same, and vice versa. There are a few formulas you can use to calculate a company's degree of operating leverage.
Operating Leverage and Profit
The DOL ratio assists analysts in determining the impact of any change in sales on company earnings. Operating leverage measures a company’s fixed as a percentage of its total costs. It is used to evaluate the breakeven point for a business—which is where sales are high enough to pay for all costs, and the profit is zero. A company with high operating leverage has a large proportion of fixed costs—which means that a substantial increase in sales can lead to outsized changes in profits.
Since businesses with higher operating leverage do not proportionately increase expenses as they increase sales, they may bring in more operating income than other companies. However, those businesses with high operating leverage face more risks if sales fall. Consequently, they are also affected more by poor management decisions and other factors that can cause losses in income.
A company with low operating leverage has a large proportion of variable costs—which means that it potentially earns a smaller gross profit on each sale—but does not face as much risk from covering fixed costs if sales drop.
Most fixed costs occur regardless of sales volume. However, so long as a business earns a substantial profit on each sale and sustains adequate sales volume, fixed costs are covered, and profits are earned.
Calculating the Degree of Operating Leverage
The main formula used to calculate the degree of operating leverage divides the percent change in EBIT by the percent change in sales. For example, Company XYZ's EBIT increased by 8.58% from 2018 to 2019, and its sales increased by 6.04% during the same period. The degree of operating leverage is shown in the following table:
|Company XYZ (in millions)|
|Degree of Operating Leverage||1.4206|
The degree of operating leverage can also be calculated by subtracting the variable costs of sales and dividing that number by sales minus variable costs and fixed costs. For example, for the fiscal year ended 2019, Company A had sales of $55.63 billion, fixed costs of $11.28 billion, and variable costs of $30 billion. Company B had sales of $29.32 billion, fixed costs of $5.47 billion, and variable costs of $16.38 billion.
Company A's degree of operating leverage is ($55.63 billion - $30 billion) / ($55.63 billion - $30 billion - $11.28 billion) = 1.78. Company B's degree of operating leverage is ($29.32 billion - $16.38 billion) / ($29.32 billion - $16.38 billion - $5.47 billion) = 1.73. If both companies experience a 20% increase in sales, Company A's profits rise by 35.6% and Company B's profits rise by 34.6%.
|Company A (millions $)||Company B (millions $)|
|Variable Costs (VC)||29,993||16,376|
|Fixed Costs (FC)||11,281||5,473|
|Sales - VC||25,639||12,942|
|Sales - VC - FC||14,358||7,469|
|Degree of Operating Leverage||1.79||1.73|