What is Operating Leverage

The use of fixed assets in generating earnings is referred to as operating leverage. Operating Leverage is measured by comparing the change in profits to the change in sales. Higher levels of operating leverage tend to result in wider variations in profits given a change in sales. This variation is called operating risks. Therefore, higher levels of fixed costs are often associated with high levels of operating risks which in turn leads to fluctuations of earnings given a change in sales.

Breakeven analysis is often used in conjunction with operating leverage. As we increase sales beyond the breakeven point, the effects of operating leverage diminish since the sales base we are using has increased. We can use breakeven analysis to calculate operating leverage.

Degree of Operating Leverage (DOL) = % Change in EBIT / % Change in Sales

EXAMPLE: Price of Product = $ 10.00, Variable Cost per unit = $ 6.00, Fixed Costs = $ 12,000 and 5,000 units are sold.

DOL = (($ 10.00 - $ 6.00) x 5,000) / ((($ 10.00 - $ 6.00) x 5,000) - $ 12,000) = 2.5

What we can conclude from our calculation is that when sales increase by say 10%, we can expect a 25% increase in earnings since we have operating leverage of 2.5. Thus, operating leverage gives us some measure of variations in earnings from changes to sales.