Degree of Operating Leverage
Candlefocus EditorThe DOL ratio is calculated as the percentage change in operating income divided by the percentage change in sales. As an example, if a company experiences an 8% increase in sales and a 36% increase in operating income, then the DOL would be 4.5 (36 divided by 8). A higher DOL means that a smaller change in sales has a larger impact on the company's operating income. Conversely, a lower DOL implies that the same change in sales has a lesser impact on the company’s operating income.
In general, companies that have a high degree of operating leverage have a large proportion of fixed costs, such as production plant and equipment, lease rentals, administrative expenses, etc. Thus, a big increase in sales can lead to outsized changes in profits. In effect, when a company has a higher degree of operating leverage, smaller fluctuations in sales volume have a larger impact on operating income and therefore contribute to greater earnings for shareholders.
Conversely, companies that have a lower DOL have a smaller proportion of fixed costs and instead have a larger proportion of variable costs, i.e. those associated with sales and production. Therefore, a small increase in sales volume may not have much of an impact on the company’s operating income since a larger portion of total costs are variable in nature.
In a nutshell, investors and analysts use the degree of operating leverage to assess how well a company will fare should there be any material change in sales volume. Companies that have a high degree of operating leverage rely more on fixed costs and therefore will experience a bigger impact on their financials should any change in sales volume occur. Conversely, companies with a lower DOL will not be as adversely affected by small fluctuations in sales volume.