Operating leverage arises when a firm has fixed operating costs in its income stream. The presence of operating leverage magnifies the effects of changes in sales to the firm’s operating earnings, i.e., a change in the volume of sales results in a “more than proportional” change in operating profit (or loss).
The degree of operating leverage is a leverage ratio that measures how a percentage change in sales volume will affect the firm’s operating profits (EBIT), at a certain level of sales.
We can calculate the DOL of a company at a particular level of sales as follows:
- Q is the quantity of sales
- P is the price per unit
- VC is the variable cost
- FC is the fixed cost
- S is Sales
- TVC is total variable cost
Annie Davis wants to determine the degree of operating leverage at sales levels of 6,000 and 8,000 units. Assume that:
Fixed costs are $100,000
Baskets are sold for $40 each
Variable costs are $15 per basket
DOL at 6000 units:
DOL at 8000 units:
DOL is interpreted as follows: A 1% increase in sales above the 8,000 unit level increases EBIT by 2% because of the existing operating leverage of the firm.
Also observe that DOL is higher at lower level of sales and it declines as sales increase.