Knowing the degree of operating leverage (DOL) of your business can help you predict how a change in sales will affect your profits. Here is an overview of how it works.
The degree of operating leverage (DOL) is a leverage ratio used in operational analysis that provides insight into how a change in sales will affect profitability. It sounds complex, but it’s easy to determine if you have your company’s financial statements for the last few years on hand and if you’re comfortable doing simple calculations. Here’s what you need to know.
Overview: What is the degree of operating leverage (DOL)?
The DOL is a financial ratio that measures the evolution of a company’s operating profit based on a percentage change in its sales. Operating income is a measure of the profit a business makes after paying its operating expenses. You can calculate yours for a given year using this operating income formula:
Operating income = Gross income – Operating expenses
Although some people use the terms interchangeably, operating profit differs from earnings before interest and taxes (EBIT), although they are similar. The EBIT formula also includes non-operating income and expenses, which are profits or losses unrelated to the main activity of the company.
The operating income formula does not include this. It focuses on core costs – those directly related to producing the company’s product – and some indirect costs such as those associated with maintaining an office space.
As long as you know your company’s sales and how to calculate your operating profit, determining your DOL isn’t too difficult. If you’re only here for the formula, you can skip a few sections to learn how to calculate your own.
A company can have a high or low DOL. A high DOL generally indicates that a business has a greater proportion of fixed costs to variable costs. This means that increasing its sales could lead to a significant increase in operating profit, but it also means that the company has a higher operating risk.
In the event of an economic downturn or if the business struggles to sell its product or service, its profits could plummet, as its high fixed costs will remain the same regardless of the business’s sales volume.
A low DOL generally indicates a business with a higher variable cost ratio, also known as the variable expense ratio. This means it has higher variable costs and modest fixed costs. When companies with a low DOL sell more products, they will have higher variable costs, so operating profit will not increase as dramatically as it would for a company with a high DOL and fewer costs. variables.
But since companies with low DOLs generally have lower fixed costs, they don’t have to sell as much to cover those expenses, and they can weather economic ups and downs better.
When determining whether you have a high or low DOL, compare your business to others in your industry rather than looking at businesses in general. Some industries naturally have higher fixed costs than others.
For example, a software company typically has more fixed costs, including often high developer salaries, while a retail store may have lower fixed costs but more variable costs due to purchasing and frequent sale of products. Focusing on your own industry is the best way to gauge your position against your competitors.
Degree of Operating Leverage (DOL) and Degree of Combined Leverage: What’s the Difference?
The degree of combined leverage (DCL) is another financial ratio that appears in accounting. It is used to assess how DOL and degree of financial leverage (DFL) affect a company’s earnings per share (EPS).
DFL is yet another leverage ratio. This tells you how sensitive the company’s EPS is to fluctuations in operating profit due to changes in capital structure or the mix of debt and equity the company uses to fund its operations. This is how you calculate the DFL:
DFL = % change in EPS / % change in earnings before interest and taxes (EBIT)
Once you know your DFL and your DOL, which you can calculate using the formula described in the next section, determining your degree of combined leverage (DCL) is easy. You simply multiply the two together:
DCL = DOL x DFL
Companies use DCL to determine what their best levels of financial and operational leverage are to maximize profits. However, not all companies watch both DOL and DFL. Those who don’t use both will have no use for the DCL formula.
How to Calculate Degree of Operating Leverage (DOL)
Follow the steps below to calculate your company’s DOL.
1. Calculate your percentage change in EBIT
To calculate your EBIT for a given year, you need to know your sales for that year as well as your operating expenses. Subtract your operating expenses from your sales to get your EBIT. For example, if your sales were $250,000 and your operating expenses were $50,000, your EBIT would be $200,000. To calculate a percentage change in your EBIT — say, from the first to the second year of your business — you would use the following formula:
% change in EBIT = ((EBIT Y2 / EBIT Y1) – 1) x 100
2. Calculate your percentage change in sales
You can calculate your percentage change in sales year over year with this formula:
Sales Change % = (Y2 Sales / Y1 Sales) – 1) x 100
3. Divide your percentage change in EBIT by your percentage change in sales
Once you have your results from the above two steps, calculating your DOL is a simple division:
DOL = % change in EBIT / % change in sales
Example of using the degree of operating leverage (DOL)
To illustrate how this works, consider a hypothetical company that had revenue of $400,000 in year one and $500,000 in year two. Its operating expenses in the first year were $75,000 and in the second year they were $90,000.
First, we would calculate the company’s EBIT for both years. Its first year EBIT would be $325,000 ($400,000 – $75,000) and its second year EBIT would be $410,000 ($500,000 – $90,000).
Next, we calculate the percentage change in EBIT from year one to year two using the formula above. We divide Year 2 EBIT of $410,000 by Year 1 EBIT of $325,000, subtract 1, and multiply by 100, which leaves us with approximately 26.2%.
Then we calculate the percent change in sales by dividing the $500,000 in year two sales by the $400,000 in year one, subtracting 1, and multiplying by 100 to get 25%.
The last step is to divide the change in EBIT (26.2%) by the change in sales (25%) to get 1.048. This is the company’s DOL. This tells you that for every 1% change in the company’s sales, its operating profit will change by approximately 1.048%.
Now it’s your turn
If you are responsible for small business accounting in your business, you need to know how to calculate your DOL. Dig into your ledger and jot down the important numbers you need, or look them up in your accounting software. Then follow the steps above to determine your DOL and check it periodically to see how it changes.