What is the degree of operating leverage? What does it mean if one firm has a measure of 40% and the other has a measure of 50%, which is better?
Degree of Operating Leverage (DOL) refers to a financial ratio that shows how a percentage change in an entity sale moves its operating income (Operating Income = Gross Income - Operating Expenses). This is achieved by evaluating an entity fixed costs and variable costs against the sales. The ratio is used to determine the operating risk an entity faces. It is calculated as follows;
Degree of Operating Leverage = Contribution margin/operating income
= Number of units (price per unit – variable cost per unit)/Number
of units (price per unit – variable cost per unit) – fixed costs
If an entity has a DOL of 40% and another has a DOL of 50%, it means the one with 40% the variable costs are high than its fixed costs, and in his situation the business does not need to increase its sales to cover its fixed costs because the action will not contribute much to the operating income. On the other hand, the entity with 50% DOL means the fixed costs are more than the variable costs. In this case the entity can increase its operating income by increasing the sales. Also, the entity must maintain high sales in order to be able to cover its fixed costs.
The only advantage with high DOL (like 50% in this case) is that having high fixed costs makes business to increase their profits, because regardless of how many products or units of services an entity sells fixed costs remain the same. On the other hand, low DOL gives entities ability to weather ups and downs as the fixed cost are lower and therefore an entity does not need to struggle to sell many products or units of service to meet the fixed costs. If the business environment is good, then high DOL is better but if it keeps fluctuating then low DOL is better.
Degree of Operating Leverage (DOL) refers to a financial ratio that shows how a percentage change in an entity sale moves its operating income (Operating Income = Gross Income - Operating Expenses). This is achieved by evaluating an entity fixed costs and variable costs against the sales. The ratio is used to determine the operating risk an entity faces. It is calculated as follows;
Degree of Operating Leverage = Contribution margin/operating income
= Number of units (price per unit – variable cost per unit)/Number
of units (price per unit – variable cost per unit) – fixed costs
If an entity has a DOL of 40% and another has a DOL of 50%, it means the one with 40% the variable costs are high than its fixed costs, and in his situation the business does not need to increase its sales to cover its fixed costs because the action will not contribute much to the operating income. On the other hand, the entity with 50% DOL means the fixed costs are more than the variable costs. In this case the entity can increase its operating income by increasing the sales. Also, the entity must maintain high sales in order to be able to cover its fixed costs.
The only advantage with high DOL (like 50% in this case) is that having high fixed costs makes business to increase their profits, because regardless of how many products or units of services an entity sells fixed costs remain the same. On the other hand, low DOL gives entities ability to weather ups and downs as the fixed cost are lower and therefore an entity does not need to struggle to sell many products or units of service to meet the fixed costs. If the business environment is good, then high DOL is better but if it keeps fluctuating then low DOL is better.
