Degree of operating leverage (DOL) is a leverage ratio used in operating analysis that gives insight into how a change in sales will affect profitability. It sounds complex, but it’s easy to figure out if you have your company’s financial statements from the past few years on hand and you’re comfortable doing some simple math. Here’s what you need to know.
Overview: What is the degree of operating leverage (DOL)?
The DOL is a financial ratio that measures how a company’s operating income changes based on a percentage change in its sales. Operating income is a measure of the profit a company makes after paying its operating expenses. You can calculate yours for a given year using this operating income formula:
Operating Income = Gross Income – Operating Expenses
Though some people use the terms interchangeably, operating income differs from earnings before interest and taxes (EBIT), though they’re similar. The EBIT formula also includes non-operating income and expenses, which are profits or losses unrelated to the company’s core business.
The operating income formula doesn’t include this. It focuses on prime costs — those directly related to producing the company’s product — and some indirect costs such as those associated with maintaining an office space.
As long as you know your company’s sales and how to calculate your operating income, figuring out your DOL isn’t too difficult. If you’re just here for the formula, you can skip down a few sections to learn how to calculate yours.
A business can have a high or low DOL. A high DOL usually indicates that a business has a larger proportion of fixed costs vs. variable costs. This means increasing its sales could cause a significant increase in operating income, but it also means the company has a higher operating risk.
If there’s an economic downturn or the business struggles to sell its product or service, its profits could plummet since its high fixed costs will remain the same, regardless of how much the company is selling.
A low DOL typically indicates a company with a higher variable cost ratio, also known as a variable expense ratio. This means it has higher variable costs and modest fixed costs. When businesses with a low DOL sell more product, they’ll have higher variable costs, so operating income won’t rise as dramatically as it would for a company with a high DOL and fewer variable costs.
But since companies with low DOLs usually have lower fixed costs, they don’t have to sell as much to cover these expenses and they can better weather economic ups and downs.
When determining whether you have a high or low DOL, compare your business to others in your industry rather than looking at businesses generally. Some industries naturally have higher fixed costs than others.
For example, a software company usually has more fixed costs, including the developers’ often high salaries, while a retail store may have lower fixed costs but more variable costs due to the frequent buying and selling of products. Focusing on your own industry vertical is the best way to assess where you stand compared to competitors.
Degree of operating leverage (DOL) vs. degree of combined leverage: What’s the difference?
Degree of combined leverage (DCL) is another financial ratio that comes up in accounting. It’s used to evaluate how the DOL and the degree of financial leverage (DFL) affect a business’s earnings per share (EPS).
DFL is yet another leverage ratio. This tells you how sensitive the company’s EPS is to fluctuations in operating income due to changes in capital structure, or the mix of debt and equity the business uses to finance its operations. Here’s how you calculate DFL:
DFL = % Change in EPS / % Change in Earnings Before Interest and Taxes (EBIT)
Once you know your DFL and your DOL, which you can calculate using the formula outlined in the next section, determining your degree of combined leverage (DCL) is easy. You just multiply the two together:
DCL = DOL x DFL
Companies use DCL to figure out what their best levels of financial and operational leverage are so they can maximize their profits. However, not all businesses look at both DOL and DFL. Those that don’t use both will have no use for the DCL formula.
How to calculate the degree of operating leverage (DOL)
Follow the steps below to calculate your business’s DOL.
1. Calculate your percent change in EBIT
To calculate your EBIT for a given year, you need to know your sales for that year as well as your operating expenses. Subtract your operating expenses from your sales to get your EBIT. For example, if your sales were $250,000 and your operating expenses were $50,000, your EBIT would be $200,000. To calculate a percent change in your EBIT — say, from year one to year two of your business — you would use the following formula:
% Change in EBIT = ((EBIT Y2 / EBIT Y1) – 1) x 100
2. Calculate your percent change in sales
You can calculate your percentage change in sales from one year to the next with this formula:
% Change in Sales = (Sales Y2 / Sales Y1) – 1) x 100
3. Divide your percent change in EBIT by your percent change in sales
Once you have your results from the two steps above, calculating your DOL is simple division:
DOL = % Change in EBIT / % Change in Sales
Example of how to use the degree of operating leverage (DOL)
To illustrate how this works, let’s consider a hypothetical business that earned $400,000 in sales in its first year and $500,000 in its second year. Its operating expenses in the first year were $75,000 and in the second year, they were $90,000.
First, we’d calculate the company’s EBIT for both years. Its Year One EBIT would be $325,000 ($400,000 – $75,000) and its Year Two EBIT would be $410,000 ($500,000 – $90,000).
Next, we calculate the percentage change in EBIT from Year One to Year Two using the formula above. We divide the $410,000 EBIT from the second year by the $325,000 EBIT from the first year, subtract 1, and multiply by 100, leaving us with about 26.2%.
Then, we’d calculate the percentage change in sales by dividing the $500,000 in sales in Year Two by the $400,000 from Year One, subtracting 1, and multiplying by 100 to get 25%.
The final step is dividing the change in EBIT (26.2%) by the change in sales (25%) to get 1.048. That’s the company’s DOL. This tells you that for every 1% change in the business’s sales, its operating income will change by about 1.048%.
Now it’s your turn
If you’re responsible for small business bookkeeping at your company, you should know how to calculate your DOL. Dig out your general ledger and note the important figures you need, or look them up in your accounting software. Then, follow the steps above to determine your DOL, and check this periodically to see how it changes.
View more information: https://www.fool.com/the-blueprint/degree-of-operating-leverage/