Most of us tend to understand leverage as the amount of debt in the balance sheet. Actually leverage has a positive connotation. It shows the extent to which you can use leverage as the fulcrum to generate more growth for the company. For that you need to understand what is operating leverage and how to use operating leverage? The operating leverage calculator that we have used later in this explanation will help you to better understand the concept of operating leverage. When we talk of leverage there are two sides to the coin. There is operating leverage and there is also the aspect of financial leverage. In this article let us focus on the concept of the operating leverage and understand how to use the Degree of Operating leverage (DOL) to tweak the profitability of the business.
Understanding all about Degree of Operating Leverage..
Leverage has two definitions. On the one hand, leverage refers to the inclusion of debt in your capital structure to make it more optimal. That is financial leverage On the other hand leverage also includes the use of fixed costs as a means to improve your profitability. That is what operating leverage or the DOL is all about. Leverage is a double-edged sword. On the one hand, it reduces your cost of capital and enhances your returns on the business. But on the other hand, it also increases your bankruptcy risk.
So, what exactly do we mean by Degree of Operating Leverage (DOL)
To understand operating leverage you first need to understand the concept of fixed and variable costs. Every company has fixed costs (that are unrelated to the level of production) and variable costs (that are related to the level of production). Examples of fixed costs are salaries, rent, license fees etc. Examples of variable costs are raw material costs, variable labour costs, fuel costs etc. The total cost of any business is a sum of these fixed costs and variable costs. This difference has very profound implications for balance sheet management.
The difference between the total sales revenues and the variable costs is referred to as the Contribution. The Contribution is assessed to see how effectively it can cover your fixed costs. Operating leverage, essentially, measures the proportion of fixed costs to your overall costs. Higher Operating Leverage means that you have more fixed costs in your cost structure. Lower operating leverage means that you have less fixed costs in your cost structure. Why is this so important? Let us understand with an example..
One needs to understand operating leverage with respect to changes in the level of production. To see the impact of operating leverage, let us look at the impact on profitability when production and sales go up by 20% after 1 year
Company A (Year 1)AmountCompany A (Year 2)AmountRevenues (a)1000Revenues (a)1200Variable Costs (b)300Variable Costs (b)360Contribution (a – b)700Contribution (a – b)840 Fixed Costs (d)600Fixed Costs (d)600 Net Operating Income (c – d)100Net Operating Income (c – d)240
Degree of Operating Leverage (DOL) in Year 1=
Contribution / Net Operating Income
In the above case, the Degree of Operating Leverage (DOL) will be 700/100 = 7 times.
Degree of Operating Leverage (DOL) in Year 2 =
Contribution / Net Operating Income
In the above case, the Degree of Operating Leverage (DOL) will be 840/240 = 3.50 times.
Why is this DOL relevant from a business point of view? Higher DOL indicates that higher is the ratio of fixed costs in the overall cost structure. That means increase in sales will not lead to a proportionate increase in total costs as fixed costs do not change with the level of production. Take the above example. While sales are up by 20% at the end of year 1, the Net Operating Income is up by 140%. Higher the DOL, higher the impact on profitability for every percentage increases in sales. In this case, the impact is 7 times (DOL).
Remember, DOL has diminishing efficiency in every subsequent year. In the above case, the Degree of Operating Leverage (DOL) has come down in the second year from 7 times to just 3.5 times. Between year 1 and year 2, the 20% increase in revenues resulted in a 140% increase in net profits as the DOL was 7 times in the first year. However, in the second year, the DOL is only 3.50 times. That means even a 30% increase in your revenues in year 3 will only increase your net profit by 105%. This is how the impact of DOL diminishes over time.
DOL is a very useful concept to understand how fixed costs need to be planned to keep the impact of leverage on profits high!