Operating Leverage Guide: How to Calculate Operating Leverage

Operating leverage, also referred to as the degree of operating leverage (DOL), is a financial ratio that measures how well a company is using its fixed costs to generate operating income. Measured as a percentage of its total costs, DOL reflects how much a company’s operating revenue would increase with any sales increase. Companies with a higher proportion of fixed costs (the costs of running a business that stay the same over a certain period) than variable costs (the costs that change in proportion to variations in sales volume and production volume) generally have greater operating leverage.

Companies generally want to achieve a high DOL to improve profitability and find their break-even point—when they make enough sales to cover their total costs. However, in certain economic conditions, the fixed costs that should hypothetically lead to higher operating revenue end up cutting into a company’s revenue.

The degree of operating leverage is an important metric for many reasons. Regularly evaluating the DOL allows a company to assess its cost structure or current business model, so it can make useful changes to increase operating profits. Working backward with the DOL formula can also help companies determine if they need to increase production or change prices to make more money.

With a high degree of operating leverage and high fixed costs, a company will generally not have to increase spending or incur additional costs to increase its sales volume with more business. High operating leverage makes it easier for the company to increase its profit margin or sales revenues on a sale-by-sale basis.

If a company has low operating leverage, it may have a higher proportion of variable assets like direct materials, inventory, and employee salaries. A company with more variable costs will typically spend more money on its fixed assets—like direct materials for making more products—to make additional sales.

A company can calculate its degree of operating leverage by taking its earnings before interest and tax (EBIT) and then dividing that number by the company’s percentage change in sales output. The operating leverage formula is as follows:

Degree of operating leverage = [number of units x (price per unit - variable cost per unit)] / number of units x (price per unit - variable cost per unit) - fixed operating costs

To calculate operating leverage, note the number of units (or products) that your company is selling, the price per unit, the variable cost per unit, and the fixed operating costs. You can find many of these numbers on your company’s income statement, cash-flow projections, or other financial statements. Here’s how to calculate your DOL:

1. 1. Calculate the earnings before interest and tax. First, subtract the variable cost per unit from the price per unit. Then, multiply this number by the number of units sold. The result is your percentage earnings before interest and tax.
2. 2. Calculate the percentage change in sales output. Next, subtract the variable cost per unit from the price per unit. Multiply this number by the number of units sold. Then subtract the fixed operating costs from that number. This is your percentage change in sales output.
3. 3. Divide to determine the operating leverage. Divide the percentage earnings before interest and taxes that you calculated in step one by the percentage change in sales output you calculated in step two: This number is your degree of operating leverage.

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