Degree of operating leverage (DOL) is financial ratio that measures the impact that the change in company revenue has on company operating income. The operating leverage of a company is determinate by the structure of fixed and variable costs. Companies that have larger fixed costs in relation to their variable costs will have higher operating leverage.
There are few different ways to calculate operating leverage. A common way is to use the ratio between the fixed and variable operating costs:
Degree of Operating leverage = Fixed Costs / Variable Costs
Another way to calculate Degree of Operating Leverage is by measuring the change in EBIT and change in revenue:
DOL= (% change in EBIT) / (% change in revenue)
Measuring the company’s operating leverage is a method for estimating the operating risk of a company. Some of the company’s cost are fixed costs and the company need to cover them no matter the business performance for that period. Other costs are variable costs that are only occur when an actual sale occur. When company has a large fraction of its operating costs in fixed costs, it is hard for the company to adjust its costs in relations to its revenue. Because of that a company with lager degree of operating leverage is considered more risky in a case of economic downturn. On the other hand, when a company’s degree of operation leverage is lower, meaning that its variable costs are a lot larger than its fixed costs, rise in revenue will not have a significant increase in operating income. In essence a company with high degree of operating leverage will have (disproportional) boost in profitability from increase in revenue but then on the other hand the company will have to maintain high revenue in order to cover for all of its fixed costs. Analysts also use operating leverage to estimate a company’s breakeven point. This is a point when the total costs and the total revenues of the company are equal. Passing the break even point means that the company has become profitable.