The degree of operating leverage (DOL) is used to measure sensitivity of a change in operating income resulting from change in sales.
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.
The degree of operating leverage (DOL) may be computed in two ways.
|DOL =||Contribution margin|
|DOL =||% Change in operating income|
|% Change in sales|
Operating income is another term for EBIT (earnings before interest and taxes).
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.
|Less: Variable Costs||37,500|
|Less: Fixed Costs||15,000|
The degree of operating leverage is:
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.
|Sales Revenue ($25/unit)||$62,500||$68,750|
|Less: Variable Costs ($10/unit)||37,500||41,250|
|Less: Fixed Costs||15,000||15,000|
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.
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%.