A:

The degree of operating leverage (DOL) is a measure used to evaluate how a company's operating income changes with respect to a percentage change in its sales. A company's operating leverage involves fixed costs and 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.

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, The Walt Disney Company (DIS) had its EBIT increase by 8.58% from 2015 to 2016, and its sales increased by 6.04% during the same period. The degree of operating leverage is:

%change in EBIT / %change in sales = 8.58% / 6.04% = 1.42. Therefore, if there is a 15% increase in the company's sales, its EBIT increases by 21.3%.

The degree of operating leverage can also be calculated by subtracting variable costs from sales and dividing it by sales minus variable costs and fixed costs. For example, for the fiscal year ended 2016, The Walt Disney Company had sales of $55.63 billion, fixed costs of $11.28 billion, and variable costs of $30 billion. Time Warner Inc. (TWX), a competitor of Disney, has sales of $29.32 billion, fixed costs of $5.47 billion, and variable costs of $16.38 billion.

Disney's degree of operating leverage is ($55.63 billion - $30 billion) / ($55.63 billion - $30 billion - $11.28 billion) = 1.78. Time Warner'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, Disney's profits rise by 35.6% and Time Warner's profits rise by 34.6%.

 

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