Operating leverage is a crucial financial metric that measures how changes in sales affect a company's operating income. It's a fundamental concept in financial analysis that helps businesses understand their cost structure and risk profile.
Operating leverage measures the degree to which a firm uses fixed costs in its operations. A higher operating leverage indicates that a larger proportion of total costs are fixed, which can lead to greater profit volatility as sales change.
Degree of Operating Leverage (DOL) = % Change in EBIT / % Change in Sales
Alternative Formula: DOL = (Q × (P - V)) / (Q × (P - V) - F)
Where:
High fixed costs due to equipment and facilities lead to high operating leverage. Example: Automotive manufacturers with significant plant investments.
High initial development costs but low variable costs create significant operating leverage potential.
Lower operating leverage due to higher variable costs (inventory) relative to fixed costs.
