What it means
Every business has costs that vary with volume and costs that do not. When sales rise, the variable costs rise with them, but the fixed costs stay where they are, so the extra sales bring in contribution at the contribution margin and all of it falls through to operating profit.
When sales fall, the fixed costs still have to be paid, and the lost contribution comes straight out of operating profit. The higher the proportion of fixed costs, the larger the contribution margin on each sale and the more operating profit swings for a given swing in sales.
The degree of operating leverage is the multiplier that summarises this: the ratio of the percentage change in operating profit to the percentage change in sales. The formula is contribution divided by operating profit.
Since operating profit is contribution less fixed costs, the ratio is greater than 1.0 whenever there are fixed costs, and it rises as fixed costs grow relative to operating profit. An equivalent form is one plus fixed costs divided by operating profit, which makes the relationship explicit: a company whose fixed costs equal twice its operating profit has a degree of operating leverage of 3.0.
Like the other leverage measures, it is a point estimate at a given level of sales: it is high when sales are near breakeven, where operating profit is small relative to contribution, and it falls towards 1.0 as sales rise well above breakeven. Operating leverage is a consequence of choices about how to run the business.
A company that builds an automated plant, signs long leases, employs salaried staff and develops its own software has chosen fixed costs, and in return it has lower variable costs, higher margins on incremental sales and, if it fills the capacity, higher profits. A company that outsources production, rents flexible space, uses contract labour and pays commission has chosen variable costs, and in return it has lower margins on incremental sales but far less exposure to a fall in volume.
Neither is right in general. High operating leverage suits stable or growing markets where the fixed capacity will be used; low operating leverage suits volatile markets where volume is uncertain.
The measure connects directly to breakeven and margin of safety. The reciprocal of the degree of operating leverage is the percentage fall in sales that reduces operating profit to zero, that is, the margin of safety as a percentage of current sales.
A company with a degree of operating leverage of 4.0 is operating 25% above its breakeven; one with 1.5 is operating 67% above. These figures translate the abstract multiplier into a plain statement of how much sales could fall before the business stops making money, which is the question a board asks when it looks at a downturn.
For planning and analysis, operating leverage explains why profit forecasts are so sensitive to volume assumptions, why a small shortfall against a sales budget can produce a large profit shortfall, and why companies in high fixed cost industries behave as they do in downturns: cutting prices to fill capacity, because any contribution above variable cost helps cover fixed costs, and suffering severe profit falls even so. It also explains the reverse: the dramatic profit growth of a high fixed cost business as it grows past breakeven, which is the story of most successful software companies.
And it sets the context for financial leverage, since a business with high operating leverage has volatile operating profit and should be cautious about adding fixed interest costs on top.
In practice
Real-world examples.
Example
A software company with development and hosting costs of $30,000,000 that vary little with customer numbers has a DOL of 5.0 at its current revenue, and each new customer adds almost the whole subscription to operating profit.
Example
A building materials distributor with a DOL of 1.4 rides out a 15% fall in sales with a 21% fall in operating profit, while a manufacturer supplying it, with a DOL of 3.5, sees a 52% fall.
Example
A hotel group calculates that its DOL of 4.5 means a 22% fall in room revenue would eliminate its operating profit, and holds cash accordingly.
Think of it
“Operating leverage is like a see-saw. With more fixed costs, small pushes create big movements.
Formula
Calculation
Degree of operating leverage (DOL) = Contribution / Operating profit
Equivalent: DOL = 1 + Fixed costs / Operating profit
Also: DOL = Percentage change in operating profit / Percentage change in sales
Margin of safety (as a percentage of sales) = 1 / DOL
Worked example. A company has sales of $10,000,000, variable costs of 60% of sales ($6,000,000) and fixed operating costs of $2,500,000.
- Contribution = $4,000,000; operating profit = $1,500,000
- DOL = $4,000,000 / $1,500,000 = 2.67 (or 1 + $2,500,000 / $1,500,000 = 2.67)
- A 10% rise in sales: contribution $4,400,000; operating profit $1,900,000, a rise of 26.7%
- Margin of safety = 1 / 2.67 = 37.5%; sales could fall to $6,250,000 before operating profit reached zero (check: contribution $2,500,000 equals fixed costs)
Two cost structures compared. Both companies have sales of $10,000,000 and operating profit of $1,500,000.
- Company L (labour-intensive): variable costs 75% of sales, fixed costs $1,000,000. Contribution $2,500,000; DOL = 2,500,000 / 1,500,000 = 1.67; breakeven sales $4,000,000; margin of safety 60%
- Company A (automated): variable costs 40% of sales, fixed costs $4,500,000. Contribution $6,000,000; DOL = 6,000,000 / 1,500,000 = 4.0; breakeven sales $7,500,000; margin of safety 25%
- Sales fall 20% to $8,000,000: Company L's contribution $2,000,000, operating profit $1,000,000 (down 33%); Company A's contribution $4,800,000, operating profit $300,000 (down 80%)
- Sales rise 20% to $12,000,000: Company L's operating profit $2,000,000 (up 33%); Company A's operating profit $2,700,000 (up 80%)
Company A earns far more in a good year and far less in a bad one. Its structure is the right one only if sales are reliably above $7,500,000.Case study
Seen in the real world.
A cinema chain with revenue of $50,000,000 had a cost structure typical of its industry: film hire and the cost of concession goods were variable at about 30% of revenue, while rent on long leases, staff on fixed rosters, utilities and maintenance were fixed at about $28,000,000. Contribution was $35,000,000, operating profit $7,000,000, and the degree of operating leverage 5.0. The board knew the business was sensitive to attendance but had not put a number on it.
A weak year for film releases cut attendance and revenue by 12%, to $44,000,000. Contribution fell to $30,800,000 and operating profit to $2,800,000, a fall of 60%: five times the fall in revenue, exactly as a DOL of 5.0 implies. The chain's lenders noticed, its dividend was halved, and the board asked for an analysis of what could be done, given that the leases and the buildings were not going anywhere.
The analysis showed that operating leverage could be reduced at the margin without changing the business. Fourteen of the chain's forty leases were due for renewal within three years, and the landlords, facing a weak retail market, were open to turnover-based rents in place of fixed ones; converting them moved about $4,000,000 of cost from fixed to variable. Staff rostering was moved to a demand-based model in which a core team was fixed and additional hours were scheduled against forecast attendance, converting a further $2,000,000.
Fixed costs fell to about $22,000,000 and variable costs rose to about 42% of revenue. At $50,000,000 of revenue the operating profit was unchanged at $7,000,000, but the DOL fell from 5.0 to 4.1, and in a repeat of the 12% fall the operating profit would be about $3,500,000 rather than $2,800,000, a fall of 50% instead of 60%. The board accepted that a cinema chain would always have high operating leverage, and that the analysis had bought it a modest but real reduction in volatility; the finance director's lasting change was to add the DOL and the margin of safety to the monthly board pack, so that the sensitivity of profit to attendance was visible before the next weak year rather than after it.
Watch out
Common mistakes.
- Treating the DOL as a fixed characteristic of a company; it is a point estimate that rises as sales fall towards breakeven and falls as they rise above it.
- Classifying costs as fixed or variable carelessly; many costs are semi-variable or stepped, and the DOL is only as good as the cost classification behind it.
- Judging a high DOL as bad; it is the source of high margins on incremental sales and of rapid profit growth in a rising market. It is a risk only where sales are volatile.
Questions
People also ask.
What is the difference between operating leverage and financial leverage?
Operating leverage comes from fixed operating costs and measures how operating profit responds to sales. Financial leverage comes from fixed interest costs and measures how earnings respond to operating profit. Their product, combined leverage, links sales to earnings.
How does DOL relate to breakeven?
The reciprocal of the DOL is the margin of safety: the percentage by which sales exceed breakeven. A DOL of 4.0 means the company is 25% above breakeven, so a 25% fall in sales would eliminate operating profit.
Can a company change its operating leverage?
Yes, over time, by changing the mix of fixed and variable costs: outsourcing or bringing work in-house, turnover-based or fixed rents, contract or salaried staff, owning or leasing equipment. Each choice trades margin on incremental sales against exposure to a fall in volume.
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