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Degree of Operating Leverage

Introduction

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

In a Nutshell

The DOL measures the how sensitive operating income (or EBIT) is to a 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, a DOL of 2 means that if sales increase (decrease) by 50%, operating income is expected to increase (decrease) by twice, i.e., 100%.

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. Consequently it also applies to decreases, e.g., a 15% decrease in sales would result to a 45% decrease in operating income.

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

Operating income is another term for 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 a larger change in operating income. This goes the same for decrease in sales. If sales revenues decrease, operating income will decrease at a much larger rate.

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