What is the Degree of Operating Leverage?
The degree of operating leverage (DOL) is a financial ratio that measures the sensitivity of a company’s operating income to its sales. The financial ratio shows how a change in the company’s sales will affect its operating income.
Breaking Down Degree of Operating Leverage
The degree of operating leverage is a method used to quantify a company’s operating risk. The risk arises due to the structure of fixed and variable costs. Fixed costs do not allow the company to adjust its operating costs to affect its sales. Therefore, operating risk rises with the increase in the fixed-to-variable costs proportion.
Generally, a low DOL indicates that the company’s variable costs are larger than its fixed costs. It implies that a significant increase in the company’s sales will not lead to a substantial increase in its operating income. At the same time, the company does not need to cover the large fixed costs.
A high DOL reveals that the company’s fixed costs exceed the variable costs. It indicates that the company can boost its operating income by increasing its sales. In addition, the company must be able to maintain the relatively high sales to cover all fixed costs.
Formula for Degree of Operating Leverage
The degree of operating leverage can be calculated in several different ways. First, we can use the formula from the definition of the ratio:
Since the operating leverage ratio is closely related to the company’s cost structure, we can calculate it using its contribution margin. The contribution margin is the difference between total sales and total variable costs.
Finally, if there is available information about the cost structure of a company, we can use the following formula:
- Q – the number of units
- P – the price per unit
- V – the variable cost per unit
- F – the fixed costs
Example of Degree of Operating Leverage
The management of ABC Corp. wants to determine the company’s current degree of operating leverage. The company sells 10,000 product units at an average price of $50. The variable cost per unit is $12 while the total fixed costs are $100,000.
The company’s DOL is:
Therefore, every 1% change in the company’s sales will change the company’s operating income by 1.38.
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