Operating Leverage Formula | Example | Calculation | Analysis
What is the operating leverage?
In order to measure a company’s fixed costs as a ratio of its total costs, we use operating leverage. So, it is a cost-accounting formula that tells us the proportion in which a firm can increase its operating income by increasing its revenue. Thus, a business with sales of high margin with low variable cost has a high level of operating leverage. So, the operating leverage meaning is clear which measures the operating income by increasing revenue.
For example, software companies have high operating leverage and on the other hand consulting or services companies have low operating leverage.
How to find operating leverage?
The operating leverage equation is derived by multiplying the quantity or units with the difference between the price and the variable cost per unit and then dividing the resultant with the product of quantity multiplied with the difference between the price and the variable cost per unit minus fixed operating costs.
In order to compute the degree of operating leverage, you need to the percentage change in earning before tax and interest (EBIT) and then calculate the percentage change in sales and divide the percentage change in earnings before tax and interest (EBIT) to the percentage change in sales.
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Types of the formula for operating leverage:
You can calculate the operating leverage ratio by using the following different formulas as:
- Operating Leverage Formula 1: DOL = [ Quantity x ( Price – Variable Cost per Unit ) ] / Quantity x ( Price – Variable Cost per Unit ) – Fixed Operating Costs
- Operating Leverage Formula 2: Fixed Costs / ( Fixed Costs + Variable Costs )
- Operating Leverage Formula 3: % Change in Operating Income / % Change in Sales
- Operating Leverage Formula 4: Net Income / Fixed Costs
- Operating Leverage Formula 5: Contribution Margin / Operating Margin
Degree of operating leverage formula:
There exists a different degree of operating leverage formula which are as follows:
- Formula 1:
DOL = | % Change in operating income |
% Change in sales |
This Formula 1 can also be written down as follows, which is derived from the degree of operating leverage definition:
DOL = | % Change in EBIT |
% Change in sales |
- Formula 2: Using contribution margin and operating income we will find the DOL here in this formula,
DOL = | Contribution margin |
Operating income |
- Formula 3: Using the cost structure of the company or the variable and fixed ast as well as the sales, we will find the DOL in this formula 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
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Degree of operating leverage formula derivation:
As, you know the Degree of operating leverage is the percentage change in operating income which occurs in response to a percentage change in sales.
So, here we will see the degree of operating leverage formula derivation by the basic definition of degree of operating leverage as:
- DOL = % Change in Operating Income / % Change in Sales
Where we see that,
- % Change in Operating Income = ∆ OI / OI
Where in the above equation,
∆ OI = change in operating income, and
OI = initial operating income.
And,
- % Change in Sales = ∆ S / S
Where in the above equation,
∆ S = change in sales
S = initial sales
So, we can write basic formula for Degree Of Operating Leverage as follows:
- DOL = ∆ OI / ∆ S X S / OI
Now, we get the equation as follows by expanding the formula as:
∆ OI = ∆ Q X ( P – V )
∆ S = ∆ Q X P
S = Q X P
OI = Q X ( P – V ) – FC
Now, we will substitute the above 4 equations in the DOL formula as follows:
DOL = { ∆ Q X ( P – V ) / ∆ Q X P } X { Q X P / Q X ( P – V ) – FC }
DOL = Q X ( P – V ) / Q X ( P – V ) – FC
And here the numerator as Q X ( P – V ) is the Contribution Margin and the denominator as Q X ( P – V ) – FC is the Operating Income, which gives us the DOL formula as follows:
- DOL = Contribution Margin / Operating Income
Point to be noted:
- Operating leverage tells us the range to which a company can upturn its operating revenue by increasing its income.
- You need four variables while calculating operating income formula which are as: Quantity, Price, Variable Cost per Unit, and Fixed Operating Cost.
- the operating leverage ratio is important as we measure the impact of the firm’s basic effective expenses, which are both fixed cost or expenses as well as the variable cost or expenses.
- The Low operating leverage companies involves high costs in proportion to their sales volumes and also have lower monthly fixed costs.
- The high operating leverage companies involve more fixed costs monthly in spite of their sales.
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How to calculate operating leverage?
You can simply use the operating leverage formula for its calculation. So, let’s see some of the examples in which you will be able to see how you can calculate operating leverage.
Examples of operating leverage:
Example 1: The following details are given to us. Compute the operating leverage.
- Quantity: 1,00,000
- Unit Price: $ 12
- Variable Cost per Unit: $ 20
- Fixed Operating Costs: $ 450000
Solution:
Using the formula, and putting the given values in the formula we can get the operating leverage as follows,
- Operating Leverage = Quantity * (Price – Variable Cost per Unit) / (Quantity * (Price – Variable Cost per Unit) – Fixed Operating Costs)
Operating Leverage = 1,00,000 * ($ 12 – $ 20) / ( 1,00,000 * ($ 12 – $ 20) – $ 450000)
= 64.00 %
Example 2: Company CBF Ltd has earned $ 6,000,000 in sales after selling 2,000,000 products at $ 3 each. The variable costs for manufacturing one product amount to $ 0.10. The company’s net operating income is $ 850,000. Calculate the operating leverage for Company CBF Ltd.
Solution: So, using the formula, we have:
- Operating Leverage Ratio = Sales – Variable Cost / Operating Income
Here,
- Sales = $ 6,000,000
- Variable Cost = $ 200,000
- Operating Income = $ 850,000
Putting these values in formula as,
operating leverage Ratio = $ 6,000,000 – $ 200,000 / $ 850,000
= 6.82
This provides the establishment with an operating leverage ratio of 6.82
Analysis: We here can say that if the company increased its sales by 10 %, it should be able to increase its operating income by 68.2 %.
Operating Leverage Formula Excel:
Representing the above example 2 in excel as follows:
Example 2: Company CBF Ltd has earned $ 6,000,000 in sales after selling 2,000,000 products at $ 3 each. The variable costs for manufacturing one product amount to $ 0.10. The company’s net operating income is $ 850,000. Calculate the operating leverage for Company CBF Ltd.
Solution: So, using the formula, we have:
- Operating Leverage Ratio = Sales – Variable Cost / Operating Income
Here,
- Sales = $ 6,000,000
- Variable Cost = $ 200,000
- Operating Income = $ 850,000
Putting the values in the excel sheet:
A | B | |
1 | Sales | $ 6,000,000 |
2 | Variable Cost | $ 200,000 |
3 | Operating Income | $ 850,000 |
4 | Operating Leverage Ratio | Sales – Variable Cost / Operating Income |
5 | = B1 – B2 / B3 | |
6 | Operating Leverage Ratio | 6.82 |
Putting these values in the formula as,
operating leverage Ratio = $ 6,000,000 – $ 200,000 / $ 850,000
= 6.82
This provides the establishment with an operating leverage ratio of 6.82
Analysis: We here can say that if the company increased its sales by 10 %, it should be able to increase its operating income by 68.2 %.
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Degree Of Operating Leverage Formula Excel:
Example 1: A financial advisor wants to know the fluctuations in its operating income and revenue changes. Thus, the use of an operating leverage degree is recommended to be used. The following details are mentioned for the Attire Ltd. Company as:
Particulars | 2021 | 2020 |
EBIT (Operating Income) | $ 80,000 | $ 60,000 |
Revenue (Sales) | $ 4,10,000 | $ 250,000 |
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) | $ 80,000 | $ 60,000 |
3 | Revenue (Sales) | $ 4,10,000 | $ 250,000 |
4 |
% Change in EBIT is calculated using the formula given below
% Change in EBIT = (EBIT current year – EBIT previous year) / EBIT previous year
A | B | C | |
5 | % Change in EBIT = | (EBIT current year – EBIT previous year) / EBIT previous year X 100 | |
6 | = (B2 – C2) / B2 X 100 | ||
7 | = (80,000 – 60,000) / 80,000 X 100 | ||
8 | = 25 % |
% Change in Sales is calculated using the formula given below,
% Change in Sales = (Sales current year – Sales previous year) / Sales previous year
A | B | C | |
9 | % Change in Sales = | (Sales current year – Sales previous year) / Sales previous year | |
10 | = (B3 – C3) / B3 X 100 | ||
11 | = (410,000 – 250,000) / 4,10,000 | ||
12 | = 39.02 % |
Calculating Operating Leverage degree = % Change in EBIT / % Change in Sales
A | B | C | |
13 | Operating Leverage degree = | % change in EBIT / % Change in Sales | |
14 | = B8 / B12 | ||
15 | = 25 / 39.02 | ||
16 | = 0.640 |
Example 2: You are given the following percentage change in EBIT (Earnings Before Interest and Tax) details and percentage change in sales details in the table below. You need to calculate the degree of operating leverage with the provided tabular information.
Particulars | Amount (in $) |
% change in EBIT (Operating Income) | 8.9 |
% change in Revenue (Sales) | 2.5 |
Solution:
A | B | |
1 | Particulars | Amount (in $) |
2 | % change in EBIT (Operating Income) | 8.9 |
3 | % change in Revenue (Sales) | 2.5 |
4 | Operating Leverage degree = | = B2 / B3 |
5 | = 8.9 / 2.5 | |
6 | 3.56 |
Note: Here, EBIT refers to the earnings before tax and income
Importance of Operating Leverage:
Managers, investors, creditors, and analysts use operating leverage to know the profitability of the business and how much is the company or firm earning to cover up their fixed cost. With a high DOL the company will receive a high profitability when the economy is booming, whereas a low DOL tells us that a company is having a low proportion of fixed operating costs as compared to the variable cost of the business.
Operating Leverage Calculator:
You can also use operating leverage calculator online that can ease up your calculation and also save your time while you calculate operating leverage of the company and else you can also use degree of operating leverage calculator in case you want to calculate degree of operating leverage of the firm or business.
Conclusion:
Managers, investors, creditors, and analysts use operating leverage to know the profitability of the business and how much is the company or firm earning to cover up their fixed cost. With a high DOL the company will receive high profitability when the economy is booming, whereas a low DOL tells us that a company is having a low proportion of fixed operating costs as compared to the variable cost of the business. Thus, in all operating leverage formula is used to know the company’s operating profits.
Frequently Asked Questions
1. How do you calculate operating leverage and financial leverage formula?
In order to calculate the operating leverage, you need to by multiplying the quantity by the difference between the price and the variable cost per unit and then divide it by the product of quantity multiplied by the difference between the price and the variable cost per unit and subtracting fixed cost from it too. And financial leverage is calculated by dividing the company’s total debt by the shareholder’s equity.
2. What are the types of leverage?
Financial leverage, operating leverage and combined leverage are the different types of leverage.
3. How do you calculate operating leverage in Excel?
You can calculate operating leverage in Excel by subtracting the variable costs of sales and dividing that number by sales minus variable costs and fixed costs.