Degree of Operating Leverage (DOL)
A firm’s operating leverage is measured by its degree of operating leverage (DOL). The degree of operating leverage is the ratio by which earnings before interest and taxes (EBIT) will change in response to a change in sales, assuming the contribution margin ratio and fixed operating costs do not change.
Like degree of financial leverage, degree of operating leverage can be calculated two ways:
| Degree of Operating Leverage (DOL)= | % [of future] Change in EBIT |
| % [of future] Change in Sales |
or
| Degree of Operating Leverage (DOL)= | Contribution Margin |
| EBIT |
| Degree of Operating Leverage (DOL)= | Q (P-V) |
| Q (P-V) – F |
Q ⇒ quantity of unit sold
P ⇒ price per unit
V ⇒ variable cost per unit
F ⇒ fixed cost
Multiplying we have :
| Degree of Operating Leverage (DOL)= | S – TVC |
| S – TVC – F |
S ⇒ sales
TVC ⇒ total variable cost
F ⇒ fixed cost
For the two methods of calculating DOL to result in the same DOL, the following assumptions are required:
- Variable costs represent the same percentage of revenue in both periods, so the contribution margin ratio (contribution margin divided by revenue) is the same for both periods.
- Total fixed costs are the same for both periods.
- Non-operating gains or losses (and discontinued operations, if applicable) are the same in both periods.
- Contribution margin ÷ EBIT is used to calculate DOL for the earlier period only.
Similar to degree of financial leverage, degree of operating leverage is also not a static measurement. A firm’s degree of operating leverage varies with its level of sales. As long as the contribution margin ratio is the same and the fixed costs and non-operating gains and losses remain the same, the degree of operating leverage decreases as sales revenue and the contribution margin increase.
Degree of operating leverage can be calculated by dividing the contribution margin by EBIT only when financial statements prepared on a variable costing basis are available. Variable costing financial statements show sales revenue on the first line and variable costs on the second line, and the difference between them is the contribution margin. When statements are prepared on an absorption costing basis though, a contribution margin is not calculated because variable costs are not isolated from fixed costs. Therefore, only someone with access to variable costing income statements or internal records that can be used to segregate variable costs from fixed costs would be able to calculate DOL by dividing the contribution margin by EBIT.
However, if financial statements are presented on the absorption costing basis and two years of income statements are presented, the degree of operating leverage can be calculated for the earlier year using the percentage of change in EBIT divided by the percentage of change in sales.
Look back at the formulas for DOL and DFL and convince yourself that if there are no fixed costs, DOL is equal to one, and that if there are no interest costs, DFL is equal to one. Values of one mean no leverage. No fixed costs, no operating leverage. No interest costs, no financial leverage. This should help tie these formulas to the concepts and help you know when you have the formulas right (or wrong). If you plug in zero for fixed costs, DOL should be one, and if you plug in zero for interest, DFL should be one.