Understanding Degree of Operating Leverage (DOL) for Better Business Insights

What Is the Degree of Operating Leverage (DOL)?

The Degree of Operating Leverage (DOL) is a tool to assess how a change in sales can affect a company's operating income. Businesses with more fixed costs compared to variable costs tend to experience higher operating leverage. This analysis helps predict how variations in sales impact profitability.

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

How to Calculate the Degree of Operating Leverage

 $\begin{aligned} &DOL = \frac{\% \text{ change in }EBIT}{\% \text{ change in sales}} \\ &\textbf{where:}\\ &EBIT=\text{earnings before income and taxes}\\ \end{aligned}$​DOL=% change in sales% change in EBIT​where: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:

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

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

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

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

What the Degree of Operating Leverage Can Tell You

A higher degree of operating leverage makes a company's earnings before interest and taxes more sensitive to sales changes, if all else is 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. High operating leverage, or more fixed costs, means a sales increase can greatly boost profits. With low operating leverage, a company relies more on variable costs, leading to smaller profits per sale but less pressure to increase sales to cover costs.

Practical Example of Applying the 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.

 $\begin{aligned} &\text{Year one }EBIT = \$500,000 - \$150,000 = \$350,000 \\ &\text{Year two }EBIT = \$600,000 - \$175,000 = \$425,000 \\ \end{aligned}$​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:

 $\begin{aligned} \% \text{ change in }EBIT &= (\$425,000 \div \$350,000) - 1 \\ &= 21.43\% \\ \% \text{ change in sales} &= (\$600,000 \div \$500,000) -1 \\ &= 20\% \\ \end{aligned}$% 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:

 $\begin{aligned} DOL &= \frac{\% \text{ change in operating income}}{\% \text{ change in sales}} \\ &= \frac{21.43\%}{ 20\%} \\ &= 1.0714 \\ \end{aligned}$DOL​=% change in sales% change in operating income​=20%21.43%​=1.0714​

Comparing Operating Leverage and 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 the degree of financial leverage, weighted by the percentage change in earnings per share over the percentage change in sales.

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.

The Bottom Line

The degree of operating leverage (DOL) is a crucial metric for understanding the sensitivity of a company's operating income to changes in sales. Companies with high fixed costs compared to variable costs exhibit high operating leverage, leading to significant profit changes with sales fluctuations.

Understanding the DOL can provide insight into a company's risk profile in response to sales volatility. Analysts and investors use DOL to gauge the impact of sales changes on earnings, aiding in investment decisions and risk assessments. The degree of combined leverage further integrates financial leverage to offer a complete picture of the potential effects on profitability.