Degree of Operating Leverage

The degree of operating leverage (DOL) is used to measure the extent of the change in operating income resulting from change in sales.

It measures the sensitivity of the change in operating income (or EBIT, earnings before interest and taxes) to the change in sales revenue.

It basically answers the question: "By how many times will operating profit increase or decrease in relation to the increase or decrease in sales?"

For example, suppose the degree of operating leverage is 3. A 10% increase in sales will result in a 30% increase in operating income. A 20% increase in sales will result in a 60% increase in operating income (i.e., 3 times the 20% increase in sales).

Degree of Operating Leverage Formula

The degree of operating leverage (DOL) may be computed in two ways.

DOL =
Contribution margin
 
Operating income

or

DOL =
% Change in operating income
 
% Change in sales

Note: Operating income is the same as EBIT (earnings before interest and taxes).

Example

The following information pertains to last week's operations of XYZ Company. The company sold 2,500 units at $25 each. Variable cost per unit is $15.

Sales Revenue  
$62,500
Less: Variable Costs  
37,500
Contribution Margin  
$25,000
Less: Fixed Costs  
15,000
Operating Income  
$10,000

The degree of operating leverage is:

DOL =
Contribution margin
   
Operating income
     
  =
$25,000
   
$10,000
     
DOL = 2.5 times

Analysis: If sales revenue changes by a certain percentage, operating income will change by 2.5 times the percentage change in sales. A 10% increase in sales will result in a 25% increase in operating income.

 
Old
 
New
Sales Revenue ($25/unit)
$62,500
 
$68,750
Less: Variable Costs ($10/unit)
37,500
 
41,250
Contribution Margin
$25,000
 
$27,500
Less: Fixed Costs
15,000
 
15,000
Operating Income
$10,000
 
$12,500

In the table above, sales revenue increased by 10% ($62,500 to $68,750). However, it resulted in a 25% increase in operating income ($10,000 to $12,500).

This is actually caused by the amplifying effect of using fixed costs. Even if sales increase, fixed costs do not change hence causing an amplified increase in operating income.

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