Operating leverage is the term used to denote the presence of fixed cost in the operating cost structure of a firm. It is a measure of magnification effect of fixed costs on operating profits or PBIT. The term ‘degree of operating leverage’ is used synonymously which is defined as the change in operating profits due to a unit change in the level of revenues.
Operating leverage deals with the investment in the fixed costs and their effect on the operating profits. When a firm invests in the fixed expenses, the increase in the level of revenue does not increase the fixed expenses and therefore the additional increase in the revenue directly triggers an increase in the operating profits.
Pretty well we can now see that the decision related to creating operating leverage is a very important decision for a business as it directly impacts the operating profit which is the direct link to shareholder’s wealth maximization. It is said that we cannot improve or implement anything till we do not measure it.
Table of Contents
A Measure of Operating Leverage / Degree of Operating Leverage:
Measurement of the effect of operating leverage is very commonly known as the degree of operating leverage. Percentage change in the operating profits due to 1 percent change in the sales is called as a degree of operating leverage.
The formula for operating leverage
|% change in EBIT (Operating Profits)|
|The degree of Operating Leverage (DOL)||=||——————————|
|% change in Revenue / Sales|
What is the meaning of DOL say it is 3? In a layman’s language, if DOL is 3, an increase in sales by 10% will increase the EBIT by 30% (3*10%). The other side for this is also true. If the sales decline by 10%, the EBIT will decrease by 30%.
|% Change in Sales||-50%||50%|
|% Change in EBIT||-100%||100%|
Let us get more clarification with the help of above example. In the example, current situation
suggests fixed cost amounting to 1000 which will not change under pessimistic as well as optimistic situations. The impact of having that operating leverage is explained by ‘% Change in EBIT’. We can clearly see that the degree of operating leverage is 2 and when the sales are going down by 50%, the EBIT going down by 100% and the same situation exists for the optimistic situation.
Interpretation and Application
For a business, operating leverage is a tool to lever a business to the next level. The use of operating leverage is a financial art of the finance manager. It is a very critical decision and has to be taken with utmost caution as we know it is like a two-edged sword. The manager has to look at the stage of the business. In nascent stage, the incurrence of fixed cost is normally not advisable. In a firm with growing sales every year, the operating leverage is a desirable decision. Why? We can see the impact in the above illustration.