The degree of operating leverage measures the amount of operating leverage in a company’s operations by comparing fixed costs with variable costs. The formula is contribution margin divided by net income. High fixed costs are considered negative as they cannot be reduced quickly.
A degree of operating leverage is a financial ratio that companies use to measure the amount of operating leverage in their operations. Operating leverage is the comparison of fixed costs with variable costs, and companies have high fixed costs that lead to an increase in the company’s operating leverage. The formula for calculating a company’s degree of operating leverage is the contribution margin divided by the company’s net income. Earnings before interest and taxes reduce a business‘s gross sales by business expenses, which will include fixed costs.
Most companies have a mix of fixed and variable costs in their operations. Fixed costs stay the same over a long period of time and are not directly influenced by the amount of production. Common fixed costs include mortgage or loan payments, rent, and lease payments. Variable costs change as companies increase or decrease their production, and include items such as materials, production, labor, or overhead that a company uses to run its production equipment or facilities. High fixed costs are considered a negative because companies cannot get rid of costs quickly, or at all, to make up for reduced sales revenue.
To calculate the degree of operating leverage, assume the following: A company’s contribution margin and net income in January are $60,000 US dollars (USD) and $20,000 US dollars, respectively. The degree of operating leverage is three (60,000 / 20,000), which means that the company’s net income will grow three times faster than sales. While this formula is a basic calculation and may not represent the economic factors that will drive company sales, it does provide a baseline for business owners and managers to use when calculating adjustments to their sales revenue and potential revenue. For example, if a company expects sales to grow 11 percent in the next 12 months, the expected increase in net income is 33 percent (11 x 3). Using the previous revenue figure above, the dollar revenue growth is $6,600 (USD).
The degree of operating leverage formula presents a basic calculation that is relevant to determining the effects of fixed costs on a business. Contribution margin is sales revenue minus the company’s variable costs needed to produce goods and services. The remaining figure represents sales dollars that a business can use to pay for fixed costs. If this figure is too low, the company will not generate enough capital to pay for normal business operations and will need to secure external financing to make up for these capital shortfalls.
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