The degree of operation leverage or DOL is a ratio that shows how well a company manages its fixed costs to generate operating income or EBIT (Earnings before Interest and Taxes). The ratio itself reflects the percentage change in operating income to a 1% change in sales. Companies with a high DOL ratio are more sensitive to change in their sales than those with low ratio values.
Low vs. high operating leverage
Low operation leverage means that a large proportion of a company’s total operating costs are variable costs. Thus, a company earns lower operating income on each incremental sale but also needs to generate lower sales to cover its fixed costs. Other things being equal, such companies are more stable and less sensitive to changes in sales volume.
High operating leverage indicates that a large proportion of a company’s total operating costs are fixed costs, which means higher operating income on each incremental sale and a need to generate higher sales to pay for its fixed costs from the other side. Typically, these companies are more responsive to changes in sales volume.
It is important to note that we should not compare the DOL ratio of companies from different industries because some of them require a higher proportion of fixed costs than others.
Formulas and Calculation
The degree of operating leverage ratio can be calculated in several ways, depending on data available. In general, the following formula can be used, where DOL is defined as the ratio between the percentage change in operating income or EBIT and the percentage change in sales obtained during a specified period:
Another way to calculate the DOL ratio is to divide a contribution margin over an operating income or EBIT obtained during a specified period:
The formula mentioned above can be represented in the following way:
where S – sales, TVC – total variable costs, FC – total fixed costs.
The degree of operating leverage can be alternatively estimated using the following formula:
In turn, the contribution margin ratio can be calculated as the contribution margin over sales:
The operating margin ratio is calculated as the operating income or EBIT over sales:
Let’s assume that the companies mentioned below have the following financial results:
|Increase in EBIT||20%|
|Increase in Sales||16%|
|Total Variable Costs, TVC||$2,500,000|
|Total Fixed Costs, FC||$1,000,000|
|Total Contribution Margin||$5,000,000|
|Operating Margin Ratio||20%|
The degree of operational leverage for each company is as follows:
Assume that all companies expect the same 5% increase in sales volume. The expected increase in operating income will be as follows:
Increase in EBIT Company A = DOL * % Change in Sales = 1.25*5% = 6.25%
Increase in EBIT Company B = 1.67*5% = 8.35%
Increase in EBIT Company C = 2.67*5% = 13.35%
The alternative scenario of a 3% decrease in sales will result in a greater decrease in operating income:
Decrease in EBIT Company A = Degree of Operating Leverage * % Change in Revenue = 1.25*3% = 3.25%
Decrease in EBIT Company B = 1.67*3% = 5.01%
Decrease in EBIT Company C = 2.67*3% = 8.01%
So, the relationship between sales and EBIT can be shown by the following graph:
The figure above shows that Company C is most vulnerable to the decrease in sales volume, and Company A is exposed to the least extent. In contrast, an increase in sales will push up the operating income of Company C to the greatest extent but Company A at the lowest.
As was mentioned above, firms having a high DOL value are vulnerable to even small changes in sales volume. In other words, a drop in sales of a few percent can cause a significant decrease in operating profit or even in operating loss. Such firms have to constantly monitor operating leverage and forecast precisely total sales volume. On the other hand, they can achieve a great increase in operating profit in favorable market conditions.