How to Calculate Degree of Operating Leverage

While leverage is the taking on of debt, margin is debt or borrowed money a firm uses to invest in other financial instruments. For example, a margin account allows an investor to borrow money at a fixed interest rate to purchase securities, options, or futures contracts in the anticipation that there will be substantially high returns. Leverage is used as a funding source when investing to expand a firm’s asset base and generate returns on risk capital; it is an investment strategy. Leverage can also refer to the amount of debt a firm uses to finance assets. If a firm is described as highly leveraged, the firm has more debt than equity. Since profits increase with volume, returns tend to be higher if volume is increased.

Like all resources, fixed cost resources should be continuously evaluated, improved and optimized. But they should only be discarded after careful consideration of the competitive situations that could arise over the long term. Operating leverage is applied for ascertaining profit planning although the CVP analysis or Break-Even analysis is used for the same purpose. It is interesting to note that the reciprocal margin of safety is expressed by operating leverage whereas Break-even analysis reveals the loss of profit at different levels of output.

Modified degree of operating leverage risk measure

The degree of operating leverage (DOL) is a financial ratio that measures the sensitivity of a company’s operating income to its sales. This financial metric shows how a change in the company’s sales will affect its operating income. An operating leverage under 1 means that a company pays more in variable costs than it earns from each sale.

Despite the fact that both operating leverage and financial
leverage are concepts that have been discussed and analyzed for decades, there is
substantial disparity in how they are defined and measured by academics and practitioners. To make it readily apparent something that is wrong with the typical
description of operating leverage, a very simple example is used in Tables 1 and 2. Assumed is that Widget Works, Inc. has fixed costs of $5,000 and variable costs per unit
of $1.00. Bridget Brothers, on the other hand, has fixed costs of $2,000 and variable
costs per unit of $1.60. Shown in Tables
1 and 2 (below) are their revenues and costs for the production of up to 25,000 units of
output. The degree of operating leverage is a method used to quantify a company’s operating risk.

Why Leverage Matters

Should a business increase or reduce the number of units it is producing? Operating leverage is the name given to the impact on
operating income of a change in the level operating leverage arises because of of output. Financial leverage is the name given
to the impact on returns of a change in the extent to which the firm’s assets are
financed with borrowed money.

However, in their model the firm always operates at full capacity, ignoring the important role of production flexibility and the relative effects of fixed versus variable costs. The management of ABC Corp. wants to determine the company’s current degree of operating leverage. The variable cost per unit is $12, while the total fixed costs are $100,000.

Operating Leverage: The Benefit of Having Capacity to Create

This is more of a snapshot of the current situation, while the DOL above is more in tune
with relative changes over time. Around your 111,111th cup of coffee, you’ll find yourself just about even. After this point, pretty much
every cup of coffee you sell is 90% profit and 10% cost.

• These types of expenses are called fixed costs, and this is where Operating Leverage comes from.
• While this is riskier, it does mean that every sale made after the break-even point will generate a higher contribution to profit.
• Using the fixed costs and variable costs, the model of leverage that can be used is the ratio of fixed costs to
  total costs.
• Companies with high operating leverage can make more money from each additional sale if they don’t have to increase costs to produce more sales.

A higher proportion of fixed costs in the production process means that the operating leverage is higher and the company has more business risk. Therefore, a
simpler, more meaningful way to the owner(s) of a business to measure operating leverage
is to compute the change in the following ratio resulting from a given increase or
decrease in the level of output from its current level. Since the operating leverage ratio is closely related to the company’s cost structure, we can calculate it using the company’s contribution margin. The contribution margin is the difference between total sales and total variable costs. It simply indicates that variable costs are the majority of the costs a business pays.