"Economic growth will boost sales and firms with a high degree of operating leverage will benefit most in terms of a lift to EPS."
― Goldman Sachs Group, after releasing and analyzing its top ten market themes for 2014
There are a number of mathematical formulas as well as financial terms that gauge how well a company is doing and how well it can do in the future. One of them is the degree of operating leverage. This value is of utmost importance, as it shows the effect of the operating leverage on the earnings of the company before interests and taxes (EBIT). If this value is high, it means that the EBIT would be unpredictable for the company.

It gives you a clear understanding of how a change in the sales would affect the profits of any business. This value is essentially used to minimize the losses that the business sustains or might go through. This Buzzle article will tell you how to calculate degree of operating leverage and explain its importance to any business.

The Theory Explained

Let us assume that a business has decent sales figures. If every sale has a high gross margin, the business is said to be leveraged to a great extent. Similarly, if the sales contribute to a slight margin, the business is less leveraged. This means that as sales increase, they contribute to more profits, which consequently leads to lesser fixed costs. Thus, businesses having more fixed costs and less variable costs have more operating leverage and vice versa.

The degree of operating leverage (DOL) is thus, a ratio that helps a business or company decide the most appropriate level of operating leverage to maximize its EBIT. It also helps understand how to minimize the risks in the business. Calculating this value appropriately will help contribute to the profits. It also helps understand how to maintain a balance between operating leverage and financial leverage to obtain maximum benefits.

What Comprises the Formula?

This value can be computed in a number of ways, as given below.

Degree of Operating Leverage (DOL) = % Change in Earnings before Interests and Taxes (EBIT) / % Change in Sales

DOL = Sales - Variable Costs / Sales - Variable Costs - Fixed Costs

DOL = Contribution Margin / Operating Income

DOL = % Change in Contribution Margin / Operating Margin

Earnings Before Interests and Taxes (EBIT)

Also known as operating income/profit, this value is a measure how much the company has earned from current operations, and this is calculated before the deductions of incomes taxes and other interests. Thus, this value excludes the earnings and expenditures from operations that have now ceased to exist. It also represents the cash that a company with less depreciation will make use of, to pay off excess debt, and so, it is carefully watched over by creditors. This measure needs to be calculated to distinguish between the success rate of different companies.

Sales Revenue

It is the total revenue that is earned through sales.

Fixed Costs

These costs do not change with the production. Examples include utilities, staff salaries, rent, etc.

Variable Costs

These costs change with the level of production. Examples include raw materials.

Analysis

As mentioned earlier, the DOL can also be considered to be a ratio of fixed costs to variable costs. It helps in determining a suitable level of operating leverage on the company earnings (before EBIT).
• If this value is high, even a small change in the percentage of sales can increase the net operating income (income leftover after fixed costs' payments are made). Here, for instance, the situation would be like having expensive labor. In this case, the focus must be to minimize labor, and make use of the fixed assets to manufacture products. Thus, there is high fixed cost and low variable cost. Therefore, if the DOL is high, you should balance the operating leverage with financial leverage. This is what will ensure maximum profits.
• If the value is low, it indicates that a large amount of the company's sales are variable costs. An example of this can be the availability of cheap labor, in which case the investments on fixed costs should be minimized and the availability of cheap labor should be used. Here, a lesser profit is incurred on each sale, but since the proportion of fixed costs is lesser, the firm need not earn a lot of sales revenue in order to pay them off. Thus, in such scenarios, the company benefits from low sales, but cannot earn extensive profits even with additional sales.
Example

Consider a company, XYZ, and its income statement:

 Revenue \$100,000 Fixed Costs \$60,000 Variable Costs \$30,000 Net Operating Income \$10,000

Here, the contribution margin = revenue - variable costs, which equals to \$ 70,000

Therefore, DOL = Contribution Margin / Net Operating Income
= 70,000 / 10,000
= 7

If you were given the data that the company manufactures wooden chairs, say at a product price of \$ 10, with variable cost at \$ 6 per chair, and \$ 12,000 as fixed costs. Assuming that 5000 chairs are sold, the DOL = [(Price per chair - Variable cost) * number of chairs] / {[(Price per chair - Variable cost) - Fixed Costs]}

= [(10 - 6) * 5000] / {[(10 - 6) * 5000] - 12,000}

= 20,000 / {20,000 - 12,000}

= 20,000 / 8,000

= 2.5

This means that if the revenue increases by 10%, the earnings can be projected to grow by 25%.

Things to Keep in Mind
• The DOL of a company/firm needs to be monitored regularly and carefully, especially if this ratio is high, since a small percentage in sales can lead to a great increase/decrease in profits.
• Keeping track of this value has a great impact on the pricing system of the firm. This is because a company with a high DOL needs to be aware that its prices should be set so low such that it never generates enough earnings to pay off the fixed costs.
• Such firms with a high DOL must be careful to forecast future revenues, since a small error can have a massive impact on the cash flows of the company.
We hope you are now aware of the basics of the degree of operating leverage, how it is calculated, and why it is so important for any company. Remember that, this value plays a massive role in determining the quality of earnings in a company. It shows how well you are using your fixed costs to generate a profit.
Saipriya Iyer
July 30, 2014