Degree Of Operating Leverage (DOL)

A quick way to approximate a firmís exposure to business risk is to compute its degree of operating leverage. The degree of operating leverage (DOL) is a measure of the sensitivity of EBIT to a change in unit volume in sales, assuming a constant pricevariable cost margin. Formally, DOL ľ Sales revenue Variable costs Sales revenue Variable costs Fixed Costs or, stated with variables, the formula for DOL can be written as: Q(p v) EBIT ľ Q(p v) Q(p v) F , where Q ľ quantity of goods sold, p ľ price per unit, v ľ variable cost per unit, F ľ total fixed cost, and EBIT ľ earnings before interest and taxes. These formulas make computing the degree of operating leverage seem fairly straightforward, but these calculations assume constant margins. Any careful analysis of business risk should include analysis of competitive conditions and other influences on the firmís margins. Why does a firmís DOL change as its level of unit sales varies? Recall the basic definition of DOL: it is the percentage change in EBIT that corresponds to a 1 percent change in unit sales. For lower levels of sales, EBIT is small. At the firmís break-even point, EBIT is zero. Therefore, any change in sales from the break-even point results in an infinite percentage change in EBIT and a DOL value of infinity. As sales volume grows, the level of EBIT also grows, but the resulting percentage change in EBIT becomes smaller and smaller, leading to reductions in the firmís degree of operating leverage. With constant margins and fixed costs, this implies that firm growth causes business risk to decline.