Question

What does degree of operating leverage tell you about a company?

Answer 1

Degree of Operating Leverage:

The degree of operating leverage (DOL) is a ratio that shows the effect a particular amount of operating leverage has on a company's earnings before interest and taxes (EBIT) over a period of time. Operating leverage is calculated using the formulae as

DOL = % change in EBIT / % change in sales

To understand the relevance, let’s take an example.

Year 1 EBIT = $1,000,000 - $300,000 = $750,000

Year 2 EBIT = $1,200,000 - $350,000 = $850,000

Next, the percentage change in the EBIT and the percentage change in the sales figures will be calculated as:

% change in EBIT = $850,000 / $700,000 - 1 = 21.43%

% change in sales = $1,200,000 / $1,000,000 -1 = 20%

DOL ratio= 21.43% / 20% = 107.14%

The ratio of 107.14 tells that at every 1% change in sale, there will be 1.0714% change in EBIT.

The Bigger the number of DOL, the more volatile and unpredictable the EBIT would be as change in Sales.

The DOL ratio is useful as it helps analysts determine the effects of a given level of operating leverage on the earnings potential of a company. . If the DOL of a company is high, this means a relatively small increase in sales can have a large effect on net operating income.

This ratio can also be used to help company decision-makers in determining the most appropriate level of operating leverage to maximize the company's EBIT.