Degree of Operating Leverage: What it is and How to Calculate it

The degree of operating leverage (DOL) of your company can assist you to estimate how a change in sales will affect your earnings. It is a leverage ratio that is used in operating analysis to determine how a change in sales would affect profitability.

What is Operating Leverage?

Operating leverage is a cost-accounting metric that determines how much a company or project may boost operating profitability by raising revenue.

A company with significant operating leverage creates sales with a high gross margin and low variable costs.

The operating leverage is used to determine a company's break-even point and to assist in the determination of optimum selling prices to make up all costs and make profits.

This can demonstrate how effectively a corporation uses fixed-cost assets to create revenues, such as its warehouse and machinery and equipment.

The more profit it can extract from the same amount of fixed assets, the higher a company's operating leverage is.

Companies can learn from analyzing operating leverage that reducing fixed costs can boost profits without changing the selling price, contribution margin, or the number of units sold.

What is the Degree of Operating Leverage?

The degree of operating leverage (DOL) is a ratio that determines how much a company's operating income will vary when sales change.

Operating leverage is higher in companies with a high percentage of fixed costs to variable costs.

It's also known as an efficiency ratio, which indicates how well organizations apply fixed and variable costs to overall net income.

The total contribution margin in dollars is divided by the pretax net income to arrive at this ratio.

High and Low Degree of Operating Leverage

A company's DOL can be high or low. A high DOL typically indicates that a company's fixed costs outnumber its variable costs.

This means that growing sales could result in a big rise in operating income, but it also represents a higher operating risk for the organization.

If there is a downturn in the economy or the company struggles to market its product or service, profitability may suffer since its high fixed expenses will remain constant regardless of how much the company sells.

A low DOL usually means a greater variable cost ratio, also known as a variable expense ratio. What this means is that it has higher variable expenses and lower fixed costs.

Businesses with a low DOL will have higher variable expenses when they sell more products, so operating income will not rise as quickly as a company with a high DOL and lower variable costs.

Companies with low DOLs, on the other hand, typically have smaller fixed costs, so they don't need to sell as much to meet these expenditures, and they can withstand economic highs and lows easier.

Compare your company to others in your field rather than looking at firms in general when deciding if you have a high or low DOL. Some sectors have higher fixed costs than some others have.

Degree of Combined Leverage and the Degree of Financial Leverage

A degree of combined leverage (DCL) is a leverage ratio that quantifies the cumulative effect of the degree of operating leverage (DOL) and financial leverage (DFL) on earnings per share (EPS) when a given change occurs in sales.

This ratio can be used to identify the best degree of financial and operating leverage for any business.

​​The degree of financial leverage, on the other hand, is determined by dividing the percentage change in a company's EPS by the percentage change in its EBIT.

The ratio shows how the EPS of a company is influenced by percentage changes in a company's EBIT. Financial leverage that is higher shows that the company's earnings are more unstable.

How to Calculate the Degree of Operating Leverage (DOL)

1. Calculate the percent change in EBIT.

You'll need to know your sales as well as your operating expenses for a given year to determine your EBIT. EBIT is calculated by subtracting operating expenses from sales.

For instance, if you had sales of $450,000 and your operating expenses were $50,000, your EBIT would be $400,000.

You would make use of the given equations to compute a percent change in your EBIT from year one to year two of your business:

% Change in EBIT = ((EBIT Y2 / EBIT Y1) - 1) x 100

2. Calculate your percent change in sales

You calculate your percentage change in sales from one year to the next using the following equation:

% Change in Sales = (Sales Y2 / Sales Y1) - 1) x 100

3. Divide your percent change in EBIT by your percent change in sales

After getting your results from the first two equations, calculating your DOL should not pose much of a challenge to you. The formula is given below:

DOL = % Change in EBIT / % Change in Sales

How to Calculate the Degree of Operating Leverage (DOL) with examples

Consider a company that made $500,000 in sales its first year and $600,000 the next year. The first year's running expenses were $90,000, while the second year was $105,000.

Calculate the company's EBIT in both years first.

Its EBIT in the first year would be $410,000 ($500,000 - $90,000), and in the second year, $500,000 ($600,000 - $100,000).

Then, using the formula: ((EBIT Y2 / EBIT Y1) - 1) x 100, calculate the % change in EBIT from Year One to Year Two.

Divide the $500,000 EBIT from the second year by the $410,000 EBIT from the first year, subtracting 1, and multiplying by 100, which would be approximately 22%.

Next is to calculate the company’s percentage change in sales using the formula: (Sales Y2 / Sales Y1) - 1) x 100

Divide the $600,000 in sales in Year Two by the $500,000 in sales in Year One, subtract 1, and multiply by 100, that would be 20%.

The last equation is to get the DOL using the formula: % Change in EBIT / % Change in Sales

Divide the change in EBIT (22%) by the change in sales (20%), to get 1.1.

The company’s DOL is 1.1.