OPERATING AND

FINANCIAL LEVERAGE
Degree of Operating
Leverage
Leverage
Leverage:
The use of the firms fixed cost in an attempt to lever
up profit.
Operating Leverage:
The use of the firms fixed operating cost to lever up
profit.
Financing Leverage:
The use of the firms fixed financing cost to lever up
profit.
DEGREE OF OPERATING
LEVERAGE (DOL)
The Degree of Operating Leverage (DOL) is the
leverage ratio that sums up the effect of an
amount of operating leverage on the companys
earnings before interests and taxes (EBIT).
Operating Leverage takes into account the
proportion of fixed costs to variable costs in the
operations of a business.
DEGREE OF OPERATING
LEVERAGE (DOL)
The Degree of Operating Leverage Ratio helps a company in understanding the
effects of operating leverage on the companys probable earnings. It is also
important in determining a suitable level of operating leverage which can be used
in order to get the most out of the companys Earnings before interest and taxes
or EBIT.
If the degree of operating leverage is high, it means that the earnings before
interest and taxes would be unpredictable for the company, even if all the other
factors remain the same.
This ratio is useful as it helps the user in determining the effects that a given level
of operating leverage has on the earnings potential of the firm. This ratio can also
be used to help the firm determine the most appropriate level of operating
leverage in order to maximize the company's EBIT.
FORMULA
=

Percentage Change in
Earnings Before Interest and Taxes
(EBIT)
Percentagechange in Sales

Example
Consider if the
% change in EBIT is 150%
% change in sales is 100%

=
% change in EBIT
% change in Sales

=
150%
100%

= . %

The percentage change in profits will be 1.50 times the percentage change in sales.

A 10% increase in sales will produce a 15% change in EBIT
A 20% increase in sales will produce a 30% change in EBIT
A 50% increase in sales will produce a 75% change in EBIT
Computing the DOL
DOL Q units
=
Q (P - V)
Q (P - V) - FC
=
Q
Q - Q
BE
Computing the DOL
DOL S dollars of sales
=
S - VC
S - VC - FC
=
EBIT + FC
EBIT
Examples
To see how operating leverage works, let's assume Company XYZ sold 1,000,000 widgets for $12
each. It has $10,000,000 of fixed costs (equipment, salaried personnel, etc.). It only costs $0.10 per
unit to make each widget.

Using this information and the formula above, we can calculate that Company XYZ's operating
leverage is:

=
[Quantity x (Price Variable Cost per Unit)]
Quantity x (Price Variable Cost per Unit) Fixed Operating Cost


=
[1,000,000 x ($12 $0.10)]
1,000,000 x ($12 $0.10) $10,000,000


=
$11,900,000
$1,900,000


= 6.26 or 626%

This means that a 10% increase in revenues should yield a 62.6% increase in operating income (10%
* 6.26).
Interpretation
A business that makes few sales, with each
sale providing a very high gross margin, is
said to be highly leveraged. A business that
makes many sales, with each sale
contributing a very slight margin, is said to
be less leveraged. As the volume of sales in
a business increases, each new sale
contributes less to fixed costs and more to
profitability.
Interpretation
A business that has a higher
proportion of fixed costs and a lower
proportion of variable costs is said to
have used more operating leverage.
Those businesses with lower fixed
costs and higher variable costs are
said to employ less operating
leverage.

DOL & Break Even Point
DOL is a quantitative measure of the
sensitivity of a firms operating profit
to a change in the firms sales.
The closer that a firm operates to its
break-even point, the higher is the
absolute value of its DOL.
Quantity Produced &
Sold Q
Profit DOL
0 -100,000 0
2,000 -50,000 -1
4,000 0 Infinite
6,000 50,000 3
8,000 100,000 2
DOL & Break Even Point
2,000 4,000 6,000 8,000
1
2
3
4
5
QUANTITY PRODUCED AND SOLD
0
-1
-2
-3
-4
-5
D
E
G
R
E
E

O
F

O
P
E
R
A
T
I
N
G

L
E
V
E
R
A
G
E

(
D
O
L
)

Q
BE
A Low Degree of Operating
Leverage
In low fixed cost and a high variable cost, since the ratio
of fixed cost to variable cost is low, the company will have
a low degree of operating leverage.
The advantage of this is that the company's breakeven
point will be quite low, resulting in a relatively low risk
level for the company. After all, if sales slowdown, the
employees can be laid off until economic conditions
improve.
The disadvantage is that profits will increase slowly as
sales increase since there is very little magnification.

A High Degree of Operating
Leverage
In a high fixed cost and a low variable cost, since the ratio of fixed
cost to variable cost is high, the company will have a high degree of
operating leverage.
The advantage of this is that the company's profits will increase
rapidly as sales increase. Once the breakeven point is reached, most
of the additional revenue from sales will flow directly into profits,
since very little will be siphoned off in the form of expenses.
The disadvantage is that the breakeven point will be quite high since
a higher level of sales is required to meet the high level of fixed costs
(payments on equipment cannot be delayed simply because sales
have slowed down).

DOL and Business Risk
Business Risk -- The inherent uncertainty in the
physical operations of the firm. Its impact is
shown in the variability of the firms operating
income (EBIT)
DOL is only one component of business risk
and becomes active only in the presence of
sales and production cost variability.
DOL magnifies the variability of operating
profits and, hence, business risk.

Impact of Operating
Leverage on Profits
in thous. Firm F Firm V Firm 2F
Sales $10 $11 $19.5
Operating Costs
Fixed 7 2 14
Variable 2 7 3
Operating Profit $1 $2 $2.5
FC/total costs .78 .22 .82
FC/sales .70 .18 .72

Application of DOL for Our
Three Firm Example
Formula used for Firm F:
DOL = [(EBIT + FC)/EBIT]


DOL$10,000 sales= 1,000 + 7,000 = 8.0
1,000
Application of DOL for Our
Three Firm Example
Formula used for Firm V:
DOL = [(EBIT + FC)/EBIT]

DOL$11,000 sales = 2,000 + 2,000 = 2.0
2,000
Application of DOL for Our
Three Firm Example
Formula used for Firm 2F:
DOL = [(EBIT + FC)/EBIT]

DOL$19,500 sales = 2,500 + 14,000
2500
= 6.6
Application of DOL for Our
Three-Firm Example
The ranked results indicate that the firm most
sensitive to the presence of operating leverage is
Firm F.
Firm F DOL = 8.0
Firm V DOL = 6.6
Firm 2F DOL = 2.0

Firm F will expect a 400% increase in profit from a
50% increase in sales
Momna Zafar
Roma Ijaz
Iqra Khalid
Sumbal Tahir
Nusrat Amin