A:

The degree of operating leverage measures the percent change of a company's earnings before interest and taxes relative to a percent change in its sales. A high degree of operating leverage indicates that the earnings before interest and taxes experience more fluctuations given a percent change in sales.

The degree of operating leverage is calculated by dividing the percent change in a company's earnings before interest and taxes by its percent change in sales over a specified period. It can also be calculated by subtracting a company's variable costs from its sales and dividing it by the sales less variable and fixed costs.

For example, company ABC has sales of \$20 million, fixed costs of \$13 million and variable costs of \$6 million. Therefore, company ABC's degree of operating leverage is 14 ((\$20 million - \$6 million)/(\$20 million - \$13 million - \$6 million)).

Since the degree of operating leverage is high, the company will experience high volatility for a small percentage change in sales. Therefore, a 1% change in sales will cause company ABC's profits to fluctuate by 14%.

On the other hand, company DEF, a competitor of company ABC, has sales of \$20 million, fixed costs of \$5 million and variable costs of \$6 million. Company DEF's degree of operating leverage is 1.56 ((\$20 million - \$6 million)/\$20 million - \$5 million - \$6 million).

The degree of operating leverage for company DEF will experience a lower level of volatility in its profits given a percent change in sales. If there is a 1% increase in sales, company DEF's profit will only increase by 1.56%, whereas company ABC will have a 14% increase in profit.

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