DOL is an important measure used to assess the consequence of fixed costs and variable costs in the business, which invariably has an effect on the profit of the business. So, let’s study the operating leverage definition, how to find degree of operating leverage, and its use.
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What Is Degree Of Operating Leverage?
The degree of operating leverage is known to be a financial ratio that is used to calculate the amount of sensitivity of a company’s operating income to its sales. You also need to access the company’s fixed cost as well as its variable cost while calculating degree of operating leverage, where the fixed cost remains constant or does not change, and on the other hand variable cost changes based on the level of production.
So, it is clear from the operating leverage definition that it is a financial competence ratio that uses fixed cost and variable cost of the business to access whether a business is profitable enough or not.
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Kinds Of Operating Degree Of Leverage
Here we will see that there exists a high degree of operating leverage as well as a low degree of operating leverage, and the reason behind them.
- High Degree Of Operating Leverage: When there is a high fixed cost in comparison to its variable cost or a low variable cost then there exists a high operating leverage degree. Therefore, an enormous rise in sales can lead to massive changes in profits.
- Low Degree Of Operating Leverage: When there is high variable cost than its fixed costs then there exists a low operating leverage degree. And this shows a smaller profit earned on each sale, but it does not need to increase sales in order to cover up its lower fixed costs.
Importance Of Degree Of Operating Leverage
The operating leverage is used by the managers, investors, creditors, and analysts to access the company’s or business financial position if it’s earning enough profits to meet its fixed and variable cost or not. Where, a high DOL can proved to be beneficial for the firm as the business is exposed to business cyclicality and fluctuating market economic conditions.
How To Calculate Degree Of Operating Leverage?
You can calculate the operating leverage by calculating percentage change in earnings before tax and interest (EBIT) and by calculating the percentage change in sales and then by dividing the percentage change in earnings before tax and interest (EBIT) by the percentage change in sales.
Degree Of Operating Leverage Formula:
You can use various formulas for calculating operating leverage degree, as:
- DOL Formula 1: The very first formula can clearly be derived from the degree of operating leverage definition as:
DOL = % Change in operating income ÷ % Change in sales
This formula can also be written down as follows:
DOL = % Change in EBIT ÷ % Change in sales
Note: Here, operating income refers to EBIT (earnings before interest and taxes).
- DOL Formula 2: This formula of DOL uses the company’s contribution margin which is the difference between the total sales and total variable costs of the company. So, here we have used the company’s cost structure, to calculate degree of operating leverage as:
DOL = Contribution margin ÷ Operating income
Note: Here, operating income refers to EBIT (earnings before interest and taxes), where as EBIT is calculated by subtracting interest and taxes from the earnings.
- DOL Formula 3: If we have some information relating the company’s cost structure then using some values we can find DOL as:
DOL = Q (P – V) Q (P – V) – F
Where, in the above DOL formula:
- Q – refers to the number of units
- P – refers to the price per unit
- V – refers to the variable cost per unit
- F – refers to the fixed costs
Or you can directly use this formula as:
DOL = Sales – Variable Cost Sales – Variable Cost – Fixed Cost
DOL Accounting Examples:
Example 1: The management of ABC Corp. wants to find degree of operating leverage and The company sells 20,000 product units at an average price of $ 150 and its variable cost per unit is $ 15, while the total fixed costs are $ 150,000.
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Solution:
Using the DOL formula a degree of operating leverage is computed as,
DOL = Q (P – V) Q (P – V) – F
Where, in the above formula:
- Q – refers to the number of units
- P – refers to the price per unit
- V – refers to the variable cost per unit
- F – refers to the fixed costs
Operating Leverage degree = 20,000 ($ 150 – $ 15) 20,000 ($ 150 – $ 15) – $ 150,000
20,000 ($ 135)/20,000 ($ 135) – $ 150,000
$ 2700,000/$ 27,00,000 – $ 150,000
$ 2700,000/$ 2550,000
Analysis: So, this tells us that if there will be 1% change in the company’s sales then the operating income of the company will be effected by 1.058 %.DOL = 1.058 %
Example 2: We are given the following data related to the sales and EBIT of a company DEF Ltd as follows:
2019 Amount (in $) | 2018 Amount (in $) | |
EBIT | $ 45,250 | $ 40,201 |
Sales | $ 20,500 | $ 19,523 |
Solution:
% Change in EBIT = EBIT 2019 – EBIT 2018 / EBIT 2018 * 100
= 45,250 – 40,201 / 40,201 * 100
= 12.58 %
% Change in Sales = Sales 2019 – Sales 2018 / Sales 2018 * 100
= 5 %
degree of operating leverage can be measured by:
DOL = % Change in EBIT / % Change in Sales
= 12.58 / 5 = 2.516
So, here our operating leverage degree is calculated as 2.52
Degree Of Operating Leverage Formula Excel:
Example 1: Jack wants to know the fluctuations in its operating income and revenue changes. Thus, use of operating leverage degree is recommended to be used. The following details are mentioned for the GHI Ltd. Company as:
Particulars | 2021 | 2020 |
EBIT (Operating Income) | $ 40,000 | $ 30,000 |
Revenue (Sales) | $ 2,10,000 | $ 150,000 |
Solution:
% Change in EBIT is calculated using the formula given below
% Change in EBIT = (EBIT current year – EBIT previous year) / EBIT previous year
Now representing this in excel as follows,
A | B | C | |
1 | Particulars | 2021 Amount (in $) | 2020 Amount (in $) |
2 | EBIT (Operating Income) | $ 40,000 | $ 30,000 |
3 | Revenue (Sales) | $ 2,10,000 | $ 150,000 |
% Change in EBIT = (EBIT current year – EBIT previous year) / EBIT previous year % Change in EBIT is calculated using the formula given below
A | B |
% Change in EBIT = | (EBIT current year – EBIT previous year) / EBIT previous year X 100 |
= (B2 – C2) / B2 X 100 | |
= (40,000 – 30,000) / 40,000 X 100 | |
= 25 % |
% Change in Sales = (Sales current year – Sales previous year) / Sales previous year% Change in Sales is calculated using the formula given below,
A | B |
% Change in Sales = | (Sales current year – Sales previous year) / Sales previous year |
= (B3 – C3) / B3 X 100 | |
= (210,000 – 150,000) / 2,10,000 | |
= 28.57 % |
Calculating Operating Leverage degree = % Change in EBIT / % Change in Sales
A | B |
Operating Leverage degree = | % change in EBIT / % Change in Sales |
= B8 / B12 | |
= 25 / 28.57 | |
= 0.88 |
Example 2: You are given the following percentage change in EBIT and percentage change in sales below. You need to calculate the DOL with the given information.
Particulars | Amount (in $) |
% change in EBIT (Operating Income) | 5.2 |
% change in Revenue (Sales) | 3.5 |
Solution:
A | B |
Particulars | Amount (in $) |
% change in EBIT (Operating Income) | 5.2 |
% change in Revenue (Sales) | 3.5 |
Operating Leverage degree = | = B2 / B3 |
= 5.2 / 3.5 | |
1.49 |
Note: Here, EBIT refers to the earnings before tax and income
Degree Of Operating Leverage Calculator
Here, we have mentioned links that you can use to calculate operating leverage degree:
- The first operating leverage calculator can be used when we have Contribution margin and Net operating income with us.
- The second operating leverage calculator can be used when we have % Change in EBIT and % change in sales with us.
FAQ
What Is The Degree Of Operating Leverage Formula?
The basic degree of operating leverage formula is percentage change in EBIT divided by Percentage change in sales.
What Does A Low Operating Leverage Mean?
A low operating leverage signifies that the company has a large proportion of variable costs and earns small amount of profit on its sales, but the company do not need to increase its sales to cover up the low fixed cost in the business.
What Is DOL And DFL?
The DOL refers to the degree of operating leverage that helps to measure the presence of fixed operating costs in the business, while DFL refers to the degree of financial leverage that helps to measure the presence of fixed financial costs in the business.
What Are The Types Of Leverage?
There exist 2 main types of leverage which are: Financial leverage and operating leverage, whereas third leverage is combined leverage obtained from Financial leverage and operating leverage.
Why Do We Calculate Degree Of Operating Leverage?
The degree of operating leverage measures how much a company’s operating income changes in response to a change in sales. The DOL ratio assists analysts in determining the impact of any change in sales on company earning.
Is It Better To Have A Higher Or Lower Degree Of Operating Leverage?
Generally speaking, high operating leverage is better than low operating leverage, as it allows businesses to earn large profits on each incremental sale. Having said that, companies with a low degree of operating leverage may find it easier to earn a profit when dealing with a lower level of sales.
What Is The Formula For Calculating Degree Of Operating Leverage?
DOL is calculated by dividing the contribution margin by the operating margin. For example, the DOL in Year 2 comes out 2.3x after dividing 22.5% (the change in operating income from Year 1 to Year 2) by 10.0% (the change in revenue from Year 1 to Year 2).
Conclusion
The DOL ratio supports predictors and financial experts in determining if there has been any impact of any change in sales on company earnings or the profits. So, here we have discussed operating leverage meaning and calculation as well as its excel templates that you find useful for assessing the business.
How to calculate degree of operating leverage?