Operating leverage becomes a reality whenever a company can expand output and sales without a corresponding increase in costs.
These circumstances see operating profits directly traceable to production and sale, increase in proportions that are more than increase in sales.
Naturally, operating profits shrink in proportions that are more than the decrease in sales when output decreases without an accompanying proportionate decrease in costs.
Degree of Operating Leverage (DOL) is usually expressed as a percentage change in operating profits to the percentage change in output. Operating leverage could either be high or low for a company.
A company with high fixed costs and low variable costs will experience a high degree of operating leverage.
Recall that fixed costs are regarded as those costs incurred and which tend to be unaffected by fluctuations in levels of activity within an accounting period and within certain output limits. Fixed cost per unit of output decreases as the number of units produced increases.
On the other hand, a variable cost varies with a measure of activity. Variable costs vary directly with the number of units produced and sold.
The exact degree of operating leverage depends on the relative proportions of fixed and variable costs and, on the company’s present level of output. Recall that DOL is measured by the relationship of the percentage change in operating profits to the percentage change in output.
The equation is;
DOL at y units = % change in operating profits/% change in output.
Company XYZ had the following operating information for 2019 and 2020;
|Production volume, Costs a .||($)||2019 ($)||($)||2020 ($)|
|Sales at $10/Unit||2,000,000||2,270,000|
|A. Fixed costs||1,000,000||1,000,000|
|B. Variable costs($4 per unit)||800,000||908,000|
|Total operating Costs (A+B)||1,800,000||1,908,000|
The percentage change in operating profit (OP) is
= (2019 OP) – (2020 OP)/(2019 OP)
= 362,000 – 200,000/200,000 = 0.81 or B1%.
The percentage change in output (Q),
= (2019 Q) – (2020 Q)/(2018 Q)
= 227,000 – 200,000/200,000 = 0.135 OR 13%.
Therefore, the DOL for XYC company is,
DOL = 81%/13% = 6.
This implies a combination of relatively high fixed costs to relatively low variable costs at its present level of output.
XYZ company can expand its operating profit by a 6 factor of any increase in output. However the relationship between fixed and variable costs is not static. So, the DOL could change.
An alternative way for calculating DOL is in terms of sales revenue:
DOL = Sale – Variable Costs/ Sales –Variable Costs – Fixed Costs
DOL = 2,000,000 – 800,000/2,000,000 – 800,000 – 1,000,000
A spreadsheet is herewith attached to aid further calculations.