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CandleFocus Glossary Editor
The degree of operating leverage (DOL) is an important metric used by investors and analysts to measure the effect of changes in sales on the financial health of a company. Put simply, the DOL ratio is a measure of how much a company's operating income changes in response to a change in sales. By understanding the degree of operating leverage, companies and their advisors can better gauge the financial impact of any given sales increase on their bottom line.
The 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.
The 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.