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
|- 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
|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.