Degree of operating leverage (DOL) is a ratio showing the percentage in EBIT (Earnings before Interest and Taxes) also referred to as operating income in response to the change in sales by 1%. For example, if this ratio equals 2, EBIT will change twice as fast in response to a certain change in sales. In other words, if sales increase by 3%, operating income will rise by 6% (2 × 3%). Knowing the degree of operating leverage helps a company’s management maximize EBIT.
The DOL ratio can be calculated in several ways. The general approach determines it as a ratio of percentage change in EBIT to a percentage change in sales.
|DOL =||% Change in EBIT|
|% Change in Sales|
In terms of contribution margin, DOL is a ratio of total contribution margin (sales less variable costs) to EBIT.
|DOL =||Total Contribution Margin|
The formula above can also be written as follows:
|DOL =||Sales - Variable Costs|
|Sales - Variable Costs - Fixed Costs|
The relationship between production output (business activity) and the degree of operating leverage is shown in the graph below.
As we can see, the value of DOL ratio could be both negative and positive. A negative value means that a business is operating under its break-even point, i.e., it has an operating loss.
A positive ratio indicates that the level of business activity exceeds the break-even point. Within a relevant range, however, the value of the DOL ratio gradually decreases as production output (business activity) increases. In other words, each incremental sale that follows will have less of an impact on EBIT.
EstroZ LLC manufactures a single product and sells it at a sales price of $500 per unit. Company management is going to sell 12,000 units during the next year, while the variable cost per unit is expected to be $300 with fixed costs of $800,000.
To estimate the DOL ratio, we apply the contribution margin approach.
Total Contribution Margin = $500 × 12,000 - $300 × 12,000 = $2,400,000
EBIT = $500 × 12,000 - $300 × 12,000 - $800,000 = $1,600,000
|DOL =||$2,400,000||= 1.5|
The degree of operating leverage of 1.5 means that EBIT will change by 1.5% in response to each 1% change in sales.
Company management considers two scenarios:
Under Scenario A, the increase in EBIT amounts to 4.5% (1.5 × 3%), and under Scenario B the reduction of EBIT is 3% (1.5 × 2%).
Assume that Company A has a DOL ratio of 1.25 and its value for Company B equals 3. The relationship between the percentage change in sales and the percentage change in EBIT for both companies is shown in the graph below.
As we can see, companies with higher DOL values are more sensitive to any change in sales. For example, an increase in sales by 5% will lead to an increase in EBIT by 6.25% for Company A and by 15% for Company B. In contrast, a decline in sales by 3% will result in a drop in EBIT by 3.75% for Company A and by 9% for Company B.