The degree of operating leverage (DOL) is a financial ratio that measures the sensitivity of a companys operating income to its sales. It is used to quantify a company's operating risk, which arises due to the structure of fixed and variable costs. A company with high operating leverage has a large proportion of fixed costs, meaning a big increase in sales can lead to outsized changes in profits. Conversely, 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.
The formula for calculating DOL varies depending on the source, but it generally involves dividing the change in operating income by the change in revenue. The formula can also be expressed as the contribution margin divided by the operating margin. The resulting number represents the risk faced by a company as a result of its percentage split between fixed and variable costs. A higher DOL implies a higher proportion of fixed costs in a company's cost structure.
Here is an example of how to calculate DOL:
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Company X has $500,000 in sales in year 1 and $800,000 in sales in year 2. Its operating income in year 1 is $100,000 and its operating income in year 2 is $228,000.
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The percentage change in sales is: ($800,000 - $500,000) / $500,000 = 60%.
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The percentage change in operating income is: ($228,000 - $100,000) / $100,000 = 128%.
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Therefore, the DOL for Company X is 128% / 60% = 2.13.
In addition to DOL, analysts may also use the degree of financial leverage (DFL) to determine the impact of any change in sales on company earnings. The degree of combined leverage (DCL) is calculated by multiplying DOL and DFL together.
