Operating Leverage

What is Operating Leverage?

The leverage associated with investment activities or asset acquisition is called operating leverage. In fact, the relationship between sales revenue and EBIT is termed as operating leverage because when the sales level increases or decreases, EBIT also changes. That means, the operating leverage measure the relationship between sales revenue and EBIT.

Finger Tips:

  • The relationship between sales revenue and EBIT is termed as operating leverage
  • EBIT may vary directly in proportion to sales.
  • EBIT may vary disproportionately to sales also.
  • Operating leverage can be calculated as a ratio of contribution to sales also.

Formula to Calculate Operating Leverage

Formula-to-calculate-operating-leverage

Explanation

It is the existence of fixed operating expenses in the enterprise’s income that decides the operating leverage. Normally the operating cost of the enterprise falls into three categories:

(a). Fixed cost
(b). Variable cost
(c). Semi-variable cost or semi-fixed cost.

Fixed cost does not vary with the volume of sales whereas variable cost varies directly with the volume of sales. Semi-variable or semi-fixed costs are partly variable and partly fixed. It means such costs are fixed up to a certain range of sales volume, and vary to higher levels when production and sales volume increase. If the semi-variable or semi-fixed cost can be apportioned appropriately into variable and fixed components, then the costs of the firm remain of two categories: fixed and variable.

In fact, operating leverage occurs when a firm has fixed costs that are to be met irrespective of the change in the sales volume. The enterprise invest in fixed assets with the hope that the volume will produce revenues more than sufficient to cover all fixed and variable costs.

After calculating the leverage by applying the formula, if the result is equal to 1, then the operating leverage indicates that there are no fixed costs and the total cost is variable in nature. It means EBIT varies in direct proportion to the sales level.

Example

For example EREHWON Ltd sells 200 units at $200 per unit and the cost of production is $140 per unit. The total cost is variable in nature, then the point of the company is equal to 200 (200-140) = $12,000 (EBIT). Suppose, the company is able to increase its sales level by 20% resulting in sales of 240 units, then the EBIT of the company is equal to 240 x (200-140) = $14,400 (EBIT).

Operating-leverage-definition-explanation-formula-examples-PA

Note: The above example illustrates that the EBIT has varied directly in proportion to sales.

Suppose the company has fixed costs of $10,000 in addition to the variable cost of 140 per unit. What would be the present and expected cost and EBIT? What is the position of operating leverage? See the following tabular representation.

Example-DOL

Example-2-OL

Degree of Operating Leverage (DOL)

The above example illustrates that the EBIT has varied disproportionately to sales. This variation of one time or six time (the above example) is known as Degree of Operating Leverage (DOL).

The DOL, at any particular sale volume, may also be calculated as a ratio of contribution to the EBIT, i.e.,

Formula-to-calculate-degree-of-operating-leverage

In the above example DOL is calculated as follows:

Calculation-of-DOL

this shows that at the present level of operating sales of 200 units, the change from this level has a DOL of six times. However, if the company’s expected sales are 240 units, then the change from this level will have DOL of 3.27 times. This example indicates that the company will have different DOL at different levels of operations. One important point to be noted here is that, if the company is operating at break-even level (i.e., the contribution is equal to fixed costs and the EBIT is zero), then defining DOL becomes difficult. For example, both contribution and fixed cost are $12,000, then EBIT is zero (12,000 – 12,000 = 0).

Therefore,

Example-3-Undefined-Degree-of-operating-level

The analysis of operating leverage helps the manager to assess the impact of change in sales on the level of operating profits (EBIT) of the enterprise. Higher DOL means higher operating profits (positive DOL), and negative DOL means operating loss.

Operating Leverage in a Nutshell

  • The operating leverage arises as a result of the fixed cost in the cost structure. If there is no fixed cost there will be no operating leverage, because the percentage change in EBIT will be the same as the percentage change in sales (i.e., one time).
  • If the contribution is equal to fixed costs, the degree of leverage remains undefined.
  • If the company is operating at a level higher than the break-even level, then DOL is considered as positive. (Both EBIT and sales vary in the same direction.)
  • If the company is operating at a level lower than the break-even level, DOL is considered to be negative (Where a contribution is less than the fixed costs).
  • If the company is operating with a fixed cost which is fixed and a variable cost that varies with the volume of sales, then DOL will vary disproportionately at different levels of operating sales.

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