What is a Degree Of Operating Leverage - DOL
The degree of operating leverage (DOL) is a multiple that measures how much the operating income of a company will change in response to a change in sales. Companies with a large proportion of fixed costs to variable costs have higher levels of operating leverage. The formula is as follows: Degree of operating leverage = % change in EBIT / % changes in sales
The Operating Leverage And DOL
BREAKING DOWN Degree Of Operating Leverage - DOL
The higher the degree of operating leverage (DOL), the more sensitive a company’s earnings before interest and taxes (EBIT) are to changes in sales, assuming all other variables remain constant. The DOL ratio helps analysts determine what the impact of any change in sales will be on the company’s earnings.
Operating leverage measures a company’s fixed costs as a percentage of its total costs. It is used to evaluate a business’ breakeven point – 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 big increase in sales can lead to outsized changes in profits. A company with low operating leverage has a large proportion of variable costs – which means that it earns a smaller profit on each sale, but does not have to increase sales as much to cover its lower fixed costs.
Degree of Operating Leverage Formulas
There are a number of ways to calculate the DOL:
Degree of operating leverage = change in operating income / changes in sales
Degree of operating leverage = contribution margin / operating income
Degree of operating leverage = sales − variable costs / sales − variable costs − fixed costs
Degree of operating leverage = contribution margin percentage / operating margin
For example, Company X has $500,000 in sales in year one and $600,000 in sales in year two. In year one, the company's operating expenses were $150,000, while in year two, the operating expenses were $175,000.
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 = % change in operating income/% change in sales = 21.43% / 20% = 1.0714