0PERATING LEVERAGE

Degree of operating leverage (DOL) measures of how sensitive net income is to percentage changes in sales.
With high leverage, a small percentage increase in sales can produce a larger percentage increase in net income.

Degree of operating leverage = Contribution margin/Net income

Example:

Sales 250000
- variable expenses 150000
Contribution margin 100000
-fixed expenses 80000
Net income 20000


100000/20000 = 5

Net income == EBIT

X(P - V) FC = EBIT

In another form the operating leverage is
Percentage change in operating profit EBIT/ Percentage change in output or sales

Calculating a DOL (Degree of operating leverage) for a single product or a single-product firm:

DOL Xunits = X(P V)/X(P V) FC = X/X XBE (BE == break-even amount in units)

Calculating the DOL for a multiproduct firm:

DOL S money units of sales = S VC/S VC FC = EBIT + FC/EBIT

Example:

Fixed costs 100000
Sold unit price 43.75
Variable unit costs 18.75
Break-even point 4000 units


The task is to determine the degree of operating leverage at sales level of 6000 and 8000 units.

DOL 6000 units = 6000/6000 4000 = 3
DOL 8000 units = 8000/8000 4000 = 2

1 % increase in sales above the 8000 unit level increases EBIT by 2 % because of the existing operating
leverage of the firm

Effects of operating leverage an example:

Actual sales at 500 units level Increased sales to 550 units
Sales 250 000 275 000
-variable expenses 150 000 165 000
Contribution margin 100 000 110 000
-fixed expenses 80 000 80 000
Net income 20 000 30 000


10 % increase in sales from 250 000 to 275 000 results in a 50 % increase in income from 20 000 to 30 000

Interpreting the results:
The closer the firm operates to its break-even point, the higher is the absolute value of its DOL.
When comparing firms the firm with highest DOL is the firm that will be most sensible to a change in sales.