Degree of Operating Leverage
The degree of operating leverage (DOL) analyzes the change of the company’s operating income due to changes in sales. It will show the sensitivity of company profit and how bad it will go when sales drop. Moreover, DOL also helps management to estimate the number of sales require if they want to increase profit.
It is related to the cost structure between variable and fixed costs. The company will have a high degree of operating leverage if its fixed cost is significantly high compared to the variable cost. So it means the company will generate high profits when sales increase. On the other hand, if the company’s fixed cost is low, it will generate a low degree of operating leverage. The company will generate low operating profit when sales increase. It is the operating risk that arises from the cost structure.
There are several different methods that can be used to analyze the company’s financial statements. The most common measures used by investors and third-party stakeholders are return on equity, price to earnings, and financial leverage. Each of these measures has its own strengths and weaknesses. The return on equity is a good measure of profitability but does not take into account the amount of debt that the company has. Price to earnings is a good measure of how expensive a stock is but does not take into account the company’s future growth prospects.
Operating leverage and financial leverage are two very important concepts in accounting. Operating leverage is when a company uses fixed costs in order to increase its operating profits. Operating leverage is a measure of how fixed costs, such as depreciation and interest expense, affect a company’s bottom line. The higher the operating leverage, the greater the proportion of fixed costs in the company’s structure and the more sensitive the company is to changes in revenue. Financial leverage, on the other hand, is a measure of how debt affects a company’s financial stability. The higher the financial leverage, the greater the proportion of debt in the company’s capital structure and the more exposed the company is to interest rate risk.
Degree of Operating Leverage Formula
There are several formulas to calculate the degree of operating leverage, but if we look closely, they just follow the mathematical logic.
Degree of operating leverage = % Change in EBIT / % Change in Sale
= % Change in operating income / % Change in sale
= Contribution margin / Operating income
= (Sale – VC) / (Sale – VC – FC)
= % of Contribution Margin / Operating Margin
Example
Company A is a shoe manufacturer in South East Asia, at the end of the year, we received the financial information as below:
| Items | Amount | Total |
|---|---|---|
| Sale price/unit | $ 100 | |
| Variable Cost/unit: | ||
| Material | 20 | |
| Labor | 25 | |
| VOH | 5 | $ 50 |
| Fixed Cost/month: | ||
| Rental | 20,000 | |
| Depreciation | 15,000 | |
| Utilities | 2,000 | |
| Other fixed Cost | 3,000 | $ 40,000 |
| Total sale during the year | 40,000 units |
Use this information to calculate the degree of leverage of company A by using all the formulas above.
DOL = Change in operating income /change in sale
Operating income = Sale – VC – FC
= (40,000 * $100) – (40,000 units * $50) – ($ 40,000 * 12 month)
= $ 1,520,000
DOL = 1, / 4,000,000
DOL = Contribution margin / Operating Income
Contribution = Sale – VC
= (40,000 * 100) – (40,000 * 50) = $ 2,000,000
DOL = 2,000,000/1.520,000 = 1.315 times
Degree of Operating Leverage Analysis
It means that the profit will change 1.31 times the change in the sale.
Sale increases 20%
To verify this, we assume the sale increase 20% (48,000 = 40,000 units * 120%)
| Items | Amount | Note |
|---|---|---|
| Sale | 4,800,000 | 48,000 units * $ 100 |
| Variable Cost | 2,400,000 | 48,000 units * $ 50 |
| Fixed Cost | 480,000 | |
| Profit | 1,920,000 |
We can see the profit increase $ 400,000 ($ 1,520,000 – $ 1,920,000) while the sale increases $ 800,000. The profit increases by 26.31% while the sale increases by 20%. Or we can say, the sale increases 20%, the profit increase 1.31 times of sale increase which is 26.31% (20% * 1.315).
This relation between sale and profit also applies when it turns a negative way. The profit will decrease by 1.315 times of the amount of sale decrease.
Sale decreased by 30%
| Items | Amount | Note |
|---|---|---|
| Sale | 2,800,000 | 28,000 units * $ 100 |
| Variable Cost | 1,400,000 | 28,000 units * $ 50 |
| Fixed Cost | 480,000 | |
| Profit | 920,000 |
The profit decrease $ 600,000 ($ 1,520,000 – $ 920,000) while sale decrease $ 1,200,000. Sale decrease 30% leads to profit decreased of 39.47% (30% * 1.315).
Recalculate DOL
For the first formula, we can calculate the DOL only we have the comparative figure. We will calculate the DOL again using the information in which the sale increases by 20%.
DOL = % change in operating profit / % change in sale
= 26.31% / 20% = 1.315 times
So the result will be the same even we use a different method.
Breaking Down The Degree of Operating Leverage
The operating leverage is a financial ratio that measures the degree of operating risk. It is the relationship between fixed and variable costs and is calculated by dividing the change in operating income over the change in sales.
The higher the ratio, the greater the degree of operating risk. The operating leverage is important because it measures the impact of sale change on the operating income. For example, if a company has a high degree of operating leverage, it means the change in the sale has a huge impact on the company operating profit. A small decrease in sales will have a big reduction in the company’s profit.
The company has to work very hard to keep up the sales volume. They need to have a strong marketing strategy to maintain the market share. It also exposes the risk of new competitors who are working for the same target customers.
On the other hand, the lower ratio shows the small impact of the sales changes over the operating income. It also has some negative points. The company will struggle to increase its profit to meet the investor’s expectations. The increase in sales has a small impact on the bottom line.
The impact of degree of operating leverage
The degree of operating leverage allows the investors to understand many factors regarding to the company.
First, the degree of operating leverage (DOL) is a key metric that provides insights into a firm’s cost structure and profitability. DOL is calculated as the ratio of fixed costs to total costs (i.e., variable + fixed costs). A high DOL indicates that a greater proportion of the firm’s costs are fixed, and vice versa. The degree of operating leverage also has a direct impact on profitability. For example, all else being equal, a firm with a higher DOL will be more profitable when sales are booming but will be more likely to incur losses during downturns. Therefore, it is important for managers to carefully consider the trade-offs associated with operating leverage before making any decisions.
The fixed costs are those that do not change with fluctuation in the output and remain constant. The main examples of fixed costs include rent, depreciation, salaries, and interest on loans. The impact of fixed cost is significant as it reduces the financial flexibility of the company and makes it difficult to respond to the changes in demand.
DOL is one metric that can be used to access the risk profile of a company. A high DOL means that a company is more exposed to fluctuations in economic conditions and business cycles. However, in the short run, a high DOL can also mean increased profits for a company. Thus, it is important for investors to carefully consider a company’s DOL when making investment decisions.
Conclusion
Degree of operating leverage is the measurement of change in company operating income due to change in sales. The operating income is the earnings before interest and tax expenses. It is the same as the change of contribution margin to operating margin.
Operating leverage exists when the ratio is greater than one. It means one percentage change in sales leads to more percentage change in operating income. Sale has a significant influence over the bottom line. For example, if the ratio is equal to 2, 1% percentage change in the sale will lead to 2% (1% x 2) change in operating income. Management needs to pay much attention to the sale to maintain a high level of profit.
If the ratio is less than one, the one percent change in sales will lead to less change in operating income. Sale has less influence on the company profit. For example, if the ratio is equal to 0.8. It means 1% change in sales will lead to 0.8% (1% x 0.8) change in operating income.