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What is the Degree of Operating Leverage?The degree of operating leverage calculates the proportional change in operating income that is caused by a percentage change in sales. This concept is used to evaluate the cost structure of a business, not including the costs of financing and taxes. For example, an entity with a high proportion of fixed costs will produce an unusually large (and positive) change in operating income if sales increase, since most of the costs incurred in the production process are fixed within a range of unit volumes. In this situation, management should guard against a reduction in sales, since this could trigger a steep decline in operating income. Conversely, the degree of operating leverage would be reduced when there is a high proportion of variable costs to fixed costs, since in this case most costs must be incurred every time a unit is produced. There is considered to be high operating leverage when a change in sales triggers an even larger change in operating income. When a publicly held company has a high degree of operating leverage, its operating income will vary significantly over time, which tends to result in a more variable stock price as investors react to the reported changes in income. Formula for the Degree of Operating LeverageThe formula for the degree of operating leverage is to divide the change in operating income by the change in sales. The calculation is: Change in operating income ÷ Change in sales = Degree of operating leverage For example, a company has a high fixed cost structure, so its operating income will increase by 12% for every 10% change in sales. This results in a 1.2x degree of operating leverage. Problems with the Degree of Operating LeverageThe main concern with using the degree of operating leverage is that the derived proportion of sales only works within a limited range of sales. If sales increase beyond this range, a business will likely exceed its production capacity, and so must invest in additional capital assets, which will further increase its fixed cost structure. Conversely, if sales decline, management may be tempted to eliminate some capacity, which will reduce fixed costs and therefore the positive effects of the degree of operating leverage. Nonetheless, this is a useful analysis tool for understanding how an organization’s profits react to changes in sales. Operating Leverage measures the proportion of a company’s cost structure that consists of fixed costs rather than variable costs. A company with more fixed costs relative to its variable costs is considered to have higher operating leverage. Table of Contents
How to Calculate Operating Leverage (Step-by-Step)Companies with a high degree of operating leverage (DOL) have a greater proportion of fixed costs that remain relatively unchanged under different production volumes, whereas those with low operating leverage have cost structures comprised of comparatively more variable costs that are directly tied to production volume.
The reason operating leverage is an essential metric to track is because the relationship between the fixed and variable costs can significantly influence a company’s scalability and profitability. As a company generates revenue, operating leverage is among the most influential factors that determine how much of that incremental revenue actually trickles down to operating income (i.e. profit). The more fixed costs there are, the more sales a company must generate in order to reach its break-even point, which is when a company’s revenue is equivalent to the sum of its total costs. Degree of Operating Leverage (DOL) and Break-Even AnalysisCompanies with higher leverage possess a greater risk of producing insufficient profits since the break-even point is positioned higher.
When a company’s revenue increases, having a high degree of leverage tends to be beneficial to its profit margins and FCFs. However, if revenue declines, the leverage can end up being detrimental to the margins of the company because the company is restricted in its ability to implement potential cost-cutting measures. How to Interpret Operating LeverageHigh vs. Low DOL by IndustryListed below in the table are some examples of industries with high and low DOL.
A shared trait for high DOL industries is that to get the business started, a large upfront payment/investment is required. For instance, a pharmaceutical drug manufacturer must spend significant amounts of capital to even get a drug designed and have a chance of receiving approval from the FDA, which is a very costly and time-consuming process. Hence, less established pharmaceutical companies are often forced to increase the pricing of their drugs to just break even and cover these costs, which is typically met with much criticism from the general public (i.e., accusations of “price gouging” in pharma). The shared characteristic of low DOL industries is that spending is tied to demand, and there are more potential cost-cutting opportunities. For example, a clothing retailer must spend a decent amount of capital to get started and begin operating in terms of finding a physical location and purchasing the initial inventory to sell to customers at its store, but the required investment is marginal relative to an airline’s spending needs (e.g., purchasing aircraft, fuel, continuous maintenance). Furthermore, another important distinction lies in how the vast majority of a clothing retailer’s future costs are unrelated to the foundational expenditures the business was founded upon (i.e., telecom ➝ network infrastructure, airlines ➝ aircraft fleet, pharmaceutical ➝ approved drugs available in the market). But rather, the clothing retailer’s expenses going forward will mostly be related to:
These two costs are conditional on past demand volume patterns (and future expectations). Since both the number of employees hired (and the number of hours worked), as well as the volume of inventory purchased, are “adjustable” factors, this provides the retailer a significant “cushion” in being able to reduce costs if deemed necessary. Liquidity Implications The catch behind having higher DOL is that for the company to receive the positive benefits, its revenue must be recurring and non-cyclical.
If sales and customer demand turned out lower than anticipated, a high DOL company could end up in financial ruin over the long run. As a result, companies with high DOL and in a cyclical industry are required to hold more cash on hand in anticipation of a potential shortfall in liquidity. For this reason, many private equity firms attempt to acquire companies with high DOL for the scalability benefits, but due to the use of significant leverage (i.e., debt financing) to fund the purchase, private equity firms will usually avoid cyclical companies. A company with high DOL coupled with a large amount of debt in its capital structure and cyclical sales could result in a disastrous outcome if the economy were to enter a recessionary environment. Operating Leverage by Industry: Telecom Company vs. Consulting FirmAn example of a company with high operating DOL would be a telecom company that has completed a build-out of its network infrastructure.
For comparability, we can take a look at a consulting firm with a low DOL.
Operating Leverage FormulaIn practice, the formula most often used to calculate operating leverage tends to be dividing the change in operating income by the change in revenue. Intuitively, DOL represents the risk faced by a company as a result of its percentage split between fixed and variable costs – so, the formula is measuring the sensitivity of a company’s operating income based on the change in “top-line” revenue. For both the numerator and denominator, the “change” (i.e., the delta symbol) refers to the year-over-year change (YoY) and can be calculated by dividing the current year balance by the prior year balance and then subtracting by 1. As an example, if operating income grew from 10k to 15k (50% increase) and revenue grew from 20k to 25k (25% increase), the DOL would be 2.0x. The 2.0x DOL implies that if revenue were to increase by 5.0%, operating income is anticipated to increase by 10.0%. Or, if revenue fell by 10%, then that would result in a 20.0% decrease in operating income. Operating Leverage = % Δ in Operating Income / % Δ in Revenue A second approach to calculating DOL involves dividing the % contribution margin by the % operating margin. The formulas for the two necessary inputs are listed below:
The contribution margin represents the percentage of revenue remaining after deducting just the variable costs, while the operating margin is the percentage of revenue left after subtracting out both variable and fixed costs. However, companies rarely disclose an in-depth breakdown of their variable and fixed costs, which makes usage of this formula less feasible unless confidential internal company data is accessible. Operating Leverage = % Contribution Margin / % Operating Margin Operating Leverage Calculator – Excel Model TemplateWe’ll now move to a modeling exercise, which you can access by filling out the form below. Step 1. High Operating Leverage Calculation ExampleTo reiterate, companies with high DOL have the potential to earn more profits on each incremental sale as the business scales. In our example, we are going to assess a company with high DOL under three different scenarios of units sold (the sales volume metric). The revenue of the company in the base case (i.e., our baseline scenario against which all other cases will be compared) is calculated by multiplying the number of units sold by the selling price per unit (or the average selling price, ASP). Since 10mm units of the product were sold at a $25.00 per unit price, revenue comes out to $250mm. The direct cost of manufacturing one unit of that product was $2.50, which we’ll multiply by the number of units sold, as we did for revenue. Upon multiplying the $2.50 cost per unit by the 10mm units sold, we get $25mm as the variable costs. Now, we are ready to calculate the contribution margin, which is the $250mm in total revenue minus the $25mm in variable costs. This comes out to $225mm as the contribution margin (which equals a margin of 90%). In the next step, we deduct the $100mm in fixed costs from the $225 contribution margin to get $125mm as the operating income (or EBIT), which comes out to be a 50% operating margin. In the base case, the ratio between the fixed costs and variable costs is 4.0x ($100mm ÷ $25mm), while the DOL is 1.8x – which we calculated by dividing the contribution margin by the operating margin. We can then extend this process for the “Upside” and “Downside” cases. The only difference now is that the number of units sold is 5mm higher in the upside case and 5mm lower in the downside case. Revenue and variable costs are both impacted by the change in the units sold since all three metrics are correlated. Under all three cases, the contribution margin remains constant at 90% because the variable costs increase (and decrease) based on the change in the units sold. But since the fixed costs are $100mm regardless of the number of units sold, the difference in operating margin amongst the cases is substantial. The operating margin in the base case is 50% as calculated earlier and the benefits of high DOL can be seen in the upside case. However, the downside case is where we can see the negative side of high DOL, as the operating margin fell from 50% to 10% due to the decrease in units sold. Despite the significant drop-off in the number of units sold (10mm to 5mm) and the coinciding decrease in revenue, the company likely had few levers to pull to limit the damage to its margins. Step 2. Low Operating Leverage Calculation ExampleRecall companies with a low DOL have a higher proportion of variable costs that depend on the number of unit sales for the specific period while having fewer fixed costs each month. This company would fit into that categorization since variable costs in the “Base” case are $200mm and fixed costs are only $50mm. In addition, in this scenario, the selling price per unit is set to $50.00 and the cost per unit is $20.00, which comes out to a contribution margin of $300mm in the base case (and 60% margin). In the “Upside Case” we can see that despite a 5mm increase in units sold, the margin expansion was roughly only 3.3% (50.0% to 53.3%). This shows how with increased scale, for companies with relatively low DOL, the benefits to margins are lessened. However, in the downside case, although the number of units sold was cut in half (10mm to 5mm), the operating margin only suffered a 10.0% decrease from 50.0% to 40.0% – reflecting the downside protection afforded to companies with low DOL. Step 3. Operating Leverage and Scalability AnalysisIn the final section, we’ll go through an example projection of a company with a high fixed cost structure and calculate the DOL using the 1st formula from earlier. Based on our hardcoded assumptions in Year 1, the ratio between fixed costs and variable costs is 5.0x ($100mm: $20mm). Here in our model, we have included two different scenarios to assess the impact the high fixed cost structure has on the company’s margins:
DOL is calculated by dividing the contribution margin by the operating margin. For example, the DOL in Year 2 comes out 2.3x after dividing 22.5% (the change in operating income from Year 1 to Year 2) by 10.0% (the change in revenue from Year 1 to Year 2). Next, if the case toggle is set to “Upside”, we can see that revenue is growing 10% each year and from Year 1 to Year 5, and the company’s operating margin expands from 40.0% to 55.8%. Just like the 1st example we had for a company with high DOL, we can see the benefits of DOL from the margin expansion of 15.8% throughout the forecast period. Variable costs were 1: 5 of the fixed costs ($20mm to $100mm) in this cost structure for the 1st period, and this grows to roughly a ~1.5: 5 ratio by Year 5 ($29mm to $100mm). But this comes out to only a $9mm increase in variable costs whereas revenue grew by $93mm ($200mm to $293mm) in the same time frame. On the other hand, if the case toggle is flipped to the “Downside” selection, revenue declines by 10% each year and we can see just how impactful the fixed cost structure can be on a company’s margins. From Year 1 to Year 5, the operating margin of our example company fell from 40.0% to a mere 13.8%, which is attributable to the fixed costs of $100mm each year. Variable costs decreased from $20mm to $13mm, in-line with the decline in revenue, yet the impact it has on the operating margin is minimal relative to the largest fixed cost outflow (the $100mm). In closing, high operating leverage is not inherently good or bad for companies. The decisive factor of whether a company should pursue a high or low DOL structure comes down to the risk tolerance of the investor/operator. Like the risk stemming from the use of financial leverage (i.e., debt financing), DOL can result in higher profits in good times but simultaneously carries a higher risk of potential losses if the company’s operating performance underwhelms. Step-by-Step Online Course Everything You Need To Master Financial ModelingEnroll in The Premium Package: Learn Financial Statement Modeling, DCF, M&A, LBO and Comps. The same training program used at top investment banks. Enroll Today How do you calculate DOL and DFL?The relationship can be expressed by the following equation:. DOL=Percentage change in operating incomePercentage change in units sold.. DFL=Percentage change in net incomePercentage change in operating income.. DTL=Percentage change in net incomePercentage change in the number of units sold.. How do you calculate operating leverage and EBIT?Degree of financial leverage formulas. DFL = (% of change in net income) / (% of change in the EBIT) In this formula, the percent change in a company's earnings before interest and taxes (EBIT) divides into the percent change of the company's net income.. DFL = (EBIT) / (EBT). |