Operating leverage is the relationship between sales and revenue (Price*Quantity of units sold) and operating profit (which is also called EBIT (earnings before interest and taxes)). It is a measure of how the potential use of fixed costs can enlarge the effect that changse in sales volume has on operating profit (EBIT).
We can represent the calculation of operating leverage as follows:
Sales – P * Q
Less: Variable operating costs – VC*Q
EBIT = (P*Q)-FC-(VC*Q)
This simplifies into:
EBIT = Q * (P-VC) – FC
When do firms have operating leverage?
If a firm has fixed costs, it has operating leverage. Because fixed cost (FC) is unchanged, an increase in sales revenue (P*Q) results in a proportionally bigger increase in EBIT (earnings before interest and taxes, which is also called operating profit). However, decrease in sales revenue (P*Q) will result in a proportionally bigger decrease in EBIT.
Increase in operating leverage increases business risk, which is a chance that the business will not be able to cover its operating costs.
How to calculate the degree of operating leverage (DOL) of the firm?
To calculate degree of operating leverage, which is just a way to measure operating leverage of the firm, we can use the following formula:
DOL =% change in EBIT/% change in sales
Therefore, if the degree of operating leverage is greater than 1, than operating leverage exists (which is the case as long as the company has fixed operating costs).
Businesses can increase their operating leverage by substituting variable costs for fixed costs, where possible. For example, salaries to sales personnel could be fixed instead of variable of units sold. Of course, many other variables need to be taken into account to make such a decision, such as consideration of how such changes would affect motivation levels of sales personnel.