OPERATING LEVERAGE Leverage is a term often used in business, and can actually mean different things for different

people. This term is often used to measure a companys overall risk. Generally speaking, an exceptionally high or low leverage score can either mean success or trouble for a company. There are many types of leverages used. One of the most popular ones is called the operating leverage. What is this, how is it computed, and what does it tell about your (or someone elses) business?By definition, it is said that operating leverage is practically similar to financial leverage. On the strict sense, this type of leverage is the relationship between growths in revenue with growth of income. Meaning, this type of ratio puts into direct comparison the level of growth against operating income. In simple words, if a company has a few sells but for big money and big margins, it has a higher leverage ratio. If a company has many small sales with smaller margin, it has a lower ratio.Operating leverage can be measured using different methods. One such method is using the cost model. This is usually interpreted in the formula fixed cost over total cost. FC / TC or FC / ( FC + VC ) According to this formula, the higher the Fixed Costs from Total Costs are, the higher the operating leverage ratio is. Another measure is: FC / TC The total cost is usually estimated using both fixed cost and variable cost. Contribution margin CM (marginal profit per unit sale) is another form to measure this type of leverage. The contribution margin is determined by variable costs: CM = Price VC A low variable cost (VC) means a high contribution margin. In this model, a higher contribution margin translates into faster profit growth with the increase of sales. Another way commonly used to measure leverage is with the use of DOL, which stands for degree of operating leverage. This is computed using different ways, but all of the equations used in this formula are created in such a way to illustrate the rate of increase in income over the rate of increase in sales. To do that, the % increase of income is compared against the % increase of sales. Another way to measure DOL is by getting the ratio between contribution margins and operating income. So in translation, DOL is used to measure operational income. This type of measurement is directly proportional to operating margin increase because as sales increase beyond break-even, operating margin values rapidly increase with it.

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. 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. Formula for determining Degree of Operating Leverage The formula used for determining the Degree of Operating Leverage or DOL is as follows: DOL = % Change in EBIT / % Change in Sales 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 operating leverage is high, then a smallest percentage change in sales can increase the net operating income. The net operating income is the amount of income that is left after payments of fixed cost are made, regardless of how much sales has been made. Since the Degree of Operating Leverage or DOL helps in determining how the change in sales volume would affect the profits of the company, it is important to ascertain the value of degree of operating leverage in order to minimize the losses to the company. A business would benefit if the can estimate the Degree of Operating Leverage or DOL. The impact of the leverage on the percentage of sales can be quite striking if not taken seriously; therefore it is really important to minimize these risks of the business. If you get a higher degree of operating leverage or DOL then you should try and balance the operating leverage to balance with the financial leverage in order to provide with profits to the company. A companys balance Degree of Operating Leverage can provide the financial leverage is an important factor contributing to business profits. Even a small percentage of increase in sales can help in having a greater proportion of profits in the company, so it is really important to maintain a balance between both financial leverage and operating leverage to yield maximum benefits.