Knowing whether a company’s operating leverage is high or low is important because those two factors, when taken into account with revenue, have an impact on profitability. A company with higher fixed costs has a higher degree of operating leverage (DOL), which then determines how much revenue is needed after costs are met — i.e. after the break-even point — to make a profit. Operating leverage calculation measures the company’s fixed costs as a formula for operating leverage percentage of its total costs. Therefore, a company with a higher fixed cost will have high operating leverage than a higher variable cost. Intuitively, the degree of operating leverage (DOL) represents the risk faced by a company as a result of its percentage split between fixed and variable costs. Companies with a high degree of operating leverage (DOL) have a greater proportion of fixed costs that remain relatively unchanged under different production volumes.
It measures the proportion of fixed versus variable costs and how changes in sales volume impact operating income. Understanding operating leverage is crucial for business owners who want to optimize profitability and make informed financial decisions and analysts who must make robust forecasts of future profitability. A high degree of operating leverage provides an indication that the company has a high proportion of fixed operating costs compared to its variable operating costs.
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The challenge that this type of business structure presents is that it also means that there will be serious declines in earnings if sales fall off. This does not only impact current Cash Flow, but it may also affect future Cash Flow as well. One important point to be noted is that if the company is operating at the break-even level (i.e., the contribution is equal to the fixed costs and EBIT is zero), then defining DOL becomes difficult. The higher the degree of operating leverage, the greater the potential danger from forecasting risk, in which a relatively small error in forecasting sales can be magnified into large errors in cash flow projections. A high DOL means that a company’s operating income is more sensitive to sales changes. Degree of combined leverage measures a company’s sensitivity of net income to sales changes.
- Even a rough idea of a firm’s operating leverage can tell you a lot about a company’s prospects.
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These industries have higher raw material costs and lower comparative fixed costs. For example, for a retailer to sell more shirts, it must first purchase more inventory. When a restaurant sells more food, it must first purchase more ingredients. The cost of goods sold for each individual sale is higher in proportion to the total sale. For these industries, an extra sale beyond the breakeven point will not add to its operating income as quickly as those in the high operating leverage industry.
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Operating leverage refers to the degree to which a company can use fixed costs to generate greater profits as sales increase. Fixed costs do not vary with activity levels, while variable costs change directly according to activity levels. In contrast, companies with low operating leverage rely more on variable costs, which means that any change in revenue will have a similar impact on operating profit, so their operating margin is less sensitive to changes in sales. The degree of operating leverage (DOL) is a multiple that measures how much the operating income of a company will change in response to a change in sales. Companies with a large proportion of fixed costs (or costs that don’t change with production) to variable costs (costs that change with production volume) have higher levels of operating leverage. The DOL ratio assists analysts in determining the impact of any change in sales on company earnings or profit.
But thanks to the internet, Inktomi’s software could be distributed to customers at almost no cost. After its fixed development costs were recovered, each additional sale was almost pure profit. Some industries tend to have a higher DOL and some tend to have a lower DOL. Those with higher fixed costs often include leases for land or buildings, or heavy R&D.
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Also, the DOL is important if you want to assess the effect of fixed costs and variable costs of the core operations of your business. While this is riskier, it does mean that every sale made after the break-even point will generate a higher contribution to profit. There are fewer variable costs in a cost structure with a high degree of operating leverage, and variable costs always cut into added productivity—though they also reduce losses from lack of sales. That indicates to us that this company might have huge variable costs relative to its sales. Similarly, we can conclude the same by realizing how little the operating leverage ratio is, at only 0.02. A company with higher variable costs (and lower operating leverage) will see a smaller profit on each sale — but because it has lower fixed costs, it likely won’t need to increase sales as much to cover those items.
For example, a DOL of 2 means that if sales increase (decrease) by 50%, operating income is expected to increase (decrease) by twice, i.e., 100%. Although you need to be careful when looking at operating leverage, it can tell you a lot about a company and its future profitability, and the level of risk it offers to investors. While operating leverage doesn’t tell the whole story, it certainly can help. Investors can come up with a rough estimate of DOL by dividing the change in a company’s operating profit by the change in its sales revenue. Given the points above, the operating leverage metric is MOST meaningful when you calculate it for companies in the same industry with roughly the same operating margins (i.e., the comparable companies).
Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. If you have the percentual change (period to period) of EBIT, put it here.
Other company costs are variable costs that are only incurred when sales occur. This includes labor to assemble products and the cost of raw materials used to make products. Some companies earn less profit on each sale but can have a lower sales volume and still generate enough to cover fixed costs. Operating leverage is a cost-accounting formula (a financial ratio) that measures the degree to which a firm or project can increase operating income by increasing revenue.
