How to use the operating leverage calculator
- Choose Two figures if you already know your contribution margin and operating income, or Sales and costs to build them from sales, variable costs and fixed costs.
- Enter the amounts for one period. Contribution margin is sales minus variable costs. Operating income is contribution margin minus fixed costs.
- Optionally open the advanced options and change the sales change to test, such as 10 percent.
- Read the degree of operating leverage and the effect of the test on operating income.
Formula
Contribution margin = sales - variable costs
Operating income = contribution margin - fixed costs
Degree of operating leverage = contribution margin / operating income
% change in operating income = DOL x % change in sales
The last line is exact when fixed costs stay fixed and variable costs move in proportion to sales.
A business with $60,000 of contribution margin
A business has sales of $150,000 and variable costs of $90,000, so its contribution margin is $60,000. With fixed costs of $40,000 its operating income is $20,000. The degree of operating leverage is $60,000 / $20,000 = 3.00.
If sales rise 10 percent, contribution margin rises to $66,000 and operating income becomes $26,000, which is a 30 percent increase. If sales fall 20 percent, contribution margin drops to $48,000 and operating income to $8,000, which is a 60 percent decrease.
Fixed costs create leverage
When a business has high fixed costs and low variable costs, most of each extra sales dollar flows straight to operating income, so profit moves a lot when sales move. That is operating leverage. The same effect works against you when sales fall, because the fixed costs still have to be paid.
The ratio is large when operating income is small compared with contribution margin, which happens close to the break even point. At break even, operating income is zero and the ratio is not defined.
Limits of the measure
The degree of operating leverage describes the business at the sales level you entered, and it changes as sales change. It assumes the cost split holds, which may not be true over a large change in volume. A negative operating income gives a negative ratio, and in that case the usual reading needs care.
To find the sales level where operating income is zero, use the break even calculator. To see how far sales can fall before reaching it, use the margin of safety calculator. The operating expense ratio calculator looks at costs as a share of revenue.
Assumptions and limits
- Fixed costs stay fixed and variable costs move in proportion to sales across the change you test.
- All figures cover the same period.
- Operating income of exactly zero is rejected because the ratio is not defined there.
- Taxes, interest and changes in selling price or product mix are not modeled.
Frequently asked questions
What is the degree of operating leverage?
It is the contribution margin divided by operating income. It tells you roughly how many percent operating income changes for each one percent change in sales.
How do I interpret a DOL of 3?
A 10 percent rise in sales would raise operating income by about 30 percent, and a 10 percent fall in sales would cut it by about 30 percent, assuming the cost behavior holds.
Why is the ratio higher near the break even point?
Because operating income is small there while contribution margin is not. A small denominator makes the ratio large, so profit swings widely for small changes in sales.
Is a high operating leverage bad?
Not by itself. It magnifies gains and losses alike. Whether it is acceptable depends on how stable your sales are and how much cushion you have.