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).
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