Degree of Operating Leverage (DOL) Definition

Capitulation

What is the degree of operating leverage (DOL)?

The degree of operating leverage (DOL) is a multiple that measures how much a company’s operating profit will change in response to a change in sales. Companies with a large proportion of fixed costs at variable costs have higher levels of operating leverage.

The DOL ratio helps analysts determine the impact of any change in sales on the company’s profits.

The formula for the degree of operating leverage is as follows:

The

reOThe=% switch EBIT% sales developmentor:EBIT=earnings before income and taxes begin {aligned} & DOL = frac {% text {change in} EBIT} {% text {change of sales}} \ & textbf {where:} \ & EBIT = text {profit before income and taxes} \ end {aligned}

ThereOThe=% sales development% switch EBITTheor:EBIT=earnings before income and taxesTheThe

Calculation of the degree of operating leverage

There are a number of other ways to calculate DOL, each based on the main formula given above:

The

Degree of operating leverage=change in operating profitsales development text {Degree of operating leverage} = frac { text {variation in operating profit}} { text {evolution in sales}}

Degree of operating leverage=sales developmentchange in operating profitTheThe

The

Degree of operating leverage=contribution margin Operating profit text {Degree of operating leverage} = frac { text {contribution margin}} { text {operating profit}}

Degree of operating leverage=Operating profitcontribution margin TheThe

The

Degree of operating leverage=sales – variable costssales – variable costs – fixed costs text {Degree of operating leverage} = frac { text {sales – variable costs}} { text {sales – variable costs – fixed costs}}

Degree of operating leverage=sales – variable costs – fixed costssales – variable costsTheThe

The

Degree of operating leverage=contribution margin percentageoperating margin text {Degree of operating leverage} = frac { text {percentage of contribution margin}} { text {operating margin}}

Degree of operating leverage=operating margincontribution margin percentageTheThe

2:27

Operating leverage and DOL

What does the degree of operating leverage tell you?

The higher the level 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 impact any change in sales will have on the company’s profits.

Operating leverage measures a company’s fixed costs as a percentage of its total costs. It is used to assess the breakeven point of a business, that is, when sales are high enough to pay all the costs and the profit is zero. A company with high operating leverage, has a large proportion of fixed costs, which means that a large increase in sales can lead to disproportionate variations in profits. A company with low operating leverage has a large proportion of variable costs, which means it makes a lower profit on each sale, but does not have to increase sales as much to cover its lower fixed costs.

Key points to remember

  • The degree of operating leverage (DOL) is a multiple that measures how much a company’s operating profit will change in response to a change in sales.
  • The DOL ratio helps analysts determine the impact of any change in sales on the company’s profits.
  • A company with high operating leverage has a large proportion of fixed costs, which means that a large increase in sales can lead to disproportionate variations in profits.

Example of use of the degree of operating leverage

As a hypothetical example, assume that Company X has sales of $ 500,000 in the first year and $ 600,000 in sales of the second year. In the first year, the company’s operating expenses amounted to $ 150,000, while in the second year, the operating expenses amounted to $ 175,000.

The

First year EBIT=$500,000$150,000=$350,000Second year EBIT=$600,000$1seven5,000=$425,000 begin {aligned} & text {First year} EBIT = 500,000 $ – 150,000 $ = 350,000 $ \ & text {Second year} EBIT = 600,000 $ – 175,000 $ = $ 425,000 \ end {aligned}

TheFirst year EBIT=$500,000$150,000=$350,000Second year EBIT=$600,000$1seven5,000=$425,000TheThe

Then, the percentage change in EBIT values ​​and the percentage change in sales figures are calculated as follows:

The

% switch EBIT=($425,000÷$350,000)1=21.43%% sales development=($600,000÷$500,000)1=20% begin {aligned} % text {change in} EBIT & = ( $ 425,000 div $ 350,000) – 1 \ & = 21.43 % \ % text {change in sales} & = ( $ 600,000 div $ 500,000) -1 \ & = 20 % \ end {aligned}

% switch EBIT% sales developmentThe=($425,000÷$350,000)1=21.43%=($600,000÷$500,000)1=20%TheThe

Finally, the DOL ratio is calculated as follows:

The

reOThe=% change in operating profit% sales development=21.43%20%=1.0seven14 begin {aligned} DOL & = frac {% text {change in operating profit}} {% text {change in sales}} \ & = frac {21.43 %} {20 % } & = 1.0714 \ end {aligned}

reOTheThe=% sales development% change in operating profitThe=20%21.43%The=1.0seven14TheThe

The difference between the degree of operating leverage and the degree of combined leverage

The degree of combined leverage (DCL) extends the degree of operating leverage to get a more complete picture of a company’s ability to generate profits from sales. It multiplies the DOL by the degrees of financial leverage (LDF) weighted by the ratio between the% change in earnings per share (EPS) and the percentage change in sales:

The

reVSThe=% switch EPS% sales development=reOThe×reFTheDCL = frac {% text {change in} EPS} {% text {change in sales}} = DOL times DFL

reVSThe=% sales development% switch EPSThe=reOThe×reFTheThe

This ratio summarizes the effects of the combination of leverage and operating leverage, and what effect this combination, or variations of that combination, has on company profits. Not all companies use both operational and financial leverage, but this formula can be used if they do. A company with a relatively high level of combined leverage is considered more risky than a company with less combined leverage, because high leverage means more fixed costs for the company. (For a related reading, see “How can I calculate the degree of operating leverage?”)

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