Degree of Operating Leverage (DOL)

What Is the Degree of Operating Leverage (DOL)?

The degree of operating leverage (DOL) is a multiple that measures how much the operating income of a company will change in response to a change in sales. Companies with a large proportion of fixed costs (or costs that don't change with production) to variable costs (costs that change with production volume) have higher levels of operating leverage.

The DOL ratio assists analysts in determining the impact of any change in sales on company earnings or profit.

Formula and Calculation of Degree of Operating Leverage

D O L = %  change in  E B I T %  change in sales where: E B I T = earnings before income and taxes \begin{aligned} &DOL = \frac{\% \text{ change in }EBIT}{\% \text{ change in sales}} \\ &\textbf{where:}\\ &EBIT=\text{earnings before income and taxes}\\ \end{aligned} DOL=% change in sales% change in EBITwhere:EBIT=earnings before income and taxes

There are a number of alternative ways to calculate the DOL, each based on the primary formula given above:

Degree of operating leverage = change in operating income changes in sales \text{Degree of operating leverage} = \frac{\text{change in operating income}}{\text{changes in sales}} Degree of operating leverage=changes in saleschange in operating income

Degree of operating leverage = contribution margin  operating income \text{Degree of operating leverage} = \frac{\text{contribution margin }}{\text{operating income}} Degree of operating leverage=operating incomecontribution margin 

Degree of operating leverage = sales – variable costs sales – variable costs – fixed costs \text{Degree of operating leverage} = \frac{\text{sales -- variable costs}}{\text{sales -- variable costs -- fixed costs}} Degree of operating leverage=sales – variable costs – fixed costssales – variable costs

Degree of operating leverage = contribution margin percentage operating margin \text{Degree of operating leverage} = \frac{\text{contribution margin percentage}}{\text{operating margin}} Degree of operating leverage=operating margincontribution margin percentage

What the Degree of Operating Leverage Can Tell You

The higher the degree of operating leverage (DOL), the more sensitive a company’s earnings before interest and taxes (EBIT) are to changes in sales, assuming all other variables remain constant. The DOL ratio helps analysts determine what the impact of any change in sales will be on the company’s earnings.

Operating leverage measures a company’s fixed costs as a percentage of its total costs. It is used to evaluate a business’ breakeven point — which is where sales are high enough to pay for all costs, and the profit is zero. A company with high operating leverage has a large proportion of fixed costs — which means that a big increase in sales can lead to outsized changes in profits. A company with low operating leverage has a large proportion of variable costs — which means that it earns a smaller profit on each sale, but does not have to increase sales as much to cover its lower fixed costs.

Example of How to Use Degree of Operating Leverage

As a hypothetical example, say Company X has $500,000 in sales in year one and $600,000 in sales in year two. In year one, the company's operating expenses were $150,000, while in year two, the operating expenses were $175,000.

Year one  E B I T = $ 5 0 0 , 0 0 0 − $ 1 5 0 , 0 0 0 = $ 3 5 0 , 0 0 0 Year two  E B I T = $ 6 0 0 , 0 0 0 − $ 1 7 5 , 0 0 0 = $ 4 2 5 , 0 0 0 \begin{aligned} &\text{Year one }EBIT = \$500,000 - \$150,000 = \$350,000 \\ &\text{Year two }EBIT = \$600,000 - \$175,000 = \$425,000 \\ \end{aligned} Year one EBIT=$500,000−$150,000=$350,000Year two EBIT=$600,000−$175,000=$425,000

Next, the percentage change in the EBIT values and the percentage change in the sales figures are calculated as:

%  change in  E B I T = ( $ 4 2 5 , 0 0 0 ÷ $ 3 5 0 , 0 0 0 ) − 1 = 2 1 . 4 3 % %  change in sales = ( $ 6 0 0 , 0 0 0 ÷ $ 5 0 0 , 0 0 0 ) − 1 = 2 0 % \begin{aligned} \% \text{ change in }EBIT &= (\$425,000 \div \$350,000) - 1 \\ &= 21.43\% \\ \% \text{ change in sales} &= (\$600,000 \div \$500,000) -1 \\ &= 20\% \\ \end{aligned} % change in EBIT% change in sales=($425,000÷$350,000)−1=21.43%=($600,000÷$500,000)−1=20%

Lastly, the DOL ratio is calculated as:

D O L = %  change in operating income %  change in sales = 2 1 . 4 3 % 2 0 % = 1 . 0 7 1 4 \begin{aligned} DOL &= \frac{\% \text{ change in operating income}}{\% \text{ change in sales}} \\ &= \frac{21.43\%}{ 20\%} \\ &= 1.0714 \\ \end{aligned} DOL=% change in sales% change in operating income=20%21.43%=1.0714

The Difference Between Degree of Operating Leverage and Degree of Combined Leverage

The degree of combined leverage (DCL) extends the degree of operating leverage to get a fuller picture of a company's ability to generate profits from sales. It multiplies DOL by degrees of financial leverage (DFL) weighted by the ratio of %change in earnings per share (EPS) over %change in sales:

D C L = %  change in  E P S %  change in sales = D O L × D F L DCL = \frac{\% \text{ change in }EPS}{\% \text{ change in sales}} = DOL \times DFL DCL=% change in sales% change in EPS=DOL×DFL

This ratio summarizes the effects of combining financial and operating leverage, and what effect this combination, or variations of this combination, has on the corporation's earnings. Not all corporations use both operating and financial leverage, but this formula can be used if they do. A firm with a relatively high level of combined leverage is seen as riskier than a firm with less combined leverage because high leverage means more fixed costs to the firm. (For related reading, see "How Do I Calculate the Degree of Operating Leverage?")