10.6 The Degree of Operating Leverage
External analysts do not have access to the data required in order to utilize the operating Leverage formula above (PQ = VQ + F). However, studying the financial statements can yield useful inferences.
The Degree of Operating Leverage (DOL) is a measure of the sensitivity of reported EBIT to changes in reported sales. It is also a metric for operating productivity and efficiency. Operating leverage is accomplished by means of the effective use of fixed-cost assets. DOL can be measured as:
DOL = (Δ EBIT) ÷ (Δ Total Sales)
This says that the greater the degree of operating leverage, the greater the change in EBIT, for a given change in Sales.
Let’s look at an example and then see what we can make of it.
| Company A | Company B | ||||
| Last Year | This Year | Last Year | This Year | ||
| EBIT | $1,000 | $1,500 | $500 | $750 | |
| Sales | 10,000 | 30,000 | 20,000 | 50,000 | |
DOLA = (1,500 – 1,000) ÷ (30,000 – 10,000) = 0.025
DOLB = (750 – 500) ÷ (50,000 – 20,000) = 0.00834
Company “A” has greater operating leverage. In other words, it gets relatively more incremental EBIT (2.5¢) out of every added dollar of sales than does Company “B” (0.8¢). The astute reader will recognize DOL as slope and recall that slope is a measure of risk. Sales would be on the horizontal axis, while EBIT would be on the vertical.
One need also recall that business risk affects the volatility of EBIT. Changes in product markets, raw materials, management, technology etc. will affect EBIT in a magnified manner both positively and negatively the greater the DOL is.
