What is operating leverage?

2.1. Degree of operating leverage

The degree of operating leverage measures a company’s earnings volatility at a given level of sales. The following formula can be used to measure the degree of operating leverage:

Degree of Operating Leverage = 

Contribution Margin

Net Income

The degree of operating leverage is essentially a multiplier: multiply percent increase in sales by the degree of operating leverage to calculate the percent increase in net operating income.

Let’s calculate the degree of operating leverage for HOL and LOL Companies:

   

HOL Company

LOL Company

(1)

Contribution margin

$75,000

$30,000

(2)

Net operating income

$15,000

$15,000

(1) ÷ (2)

Degree of operating leverage

5

2

As we can see from the table above, companies with a high operating leverage have a higher degree of operating leverage, and vice versa. For example, HOL Company’s net operating income grows five (5) times as fast as its sales (refer to the table below).

   

HOL Company

LOL Company

(1)

Increase in sales

20%

20%

(2)

Degree of operating leverage

5

2

(1) x (2)

Increase in net operating income

100%

40%

Degree of operating leverage is not a constant: it has a negative relationship with the level of sales.

  • Sales and profit increase: degree of operating leverage decreases
  • Sales and profit decrease: degree of operating leverage increases

Degree of operating leverage is greatest at the break-even point.

For example, let’s look at the trend in the degree of operating leverage for HOL Company at the different level of sales.

(1)

 

Sales

160,000

$120,000

$100,000

$80,000

(2)

 

Variable expenses

(40,000)

(30,000)

(25,000)

(20,000)

(3)

(1) – (2)

Contribution margin

120,000

90,000

75,000

60,000

(4)

 

Fixed expenses

(60,000)

(60,000)

(60,000)

(60,000)

(5)

(3) – (4)

Net operating income

60,000

30,000

15,000

0

(6)

(3) ÷ (5)

Degree of operating leverage

2

3

5

As we can see from the table above, the degree of operating leverages increases as the level of sales decreases and is greatest at the break-even point (i.e., $80,000 in sales, $0 net operating income).

Not a member?
See why people join our
online accounting course:
Lecture Contents:
Free Study Notes
Download free accounting study notes by signing up for our free newsletter (example):
First Name:
E-mail:
We never share or sell your e-mail to third parties.