I am having a hard time grasping the concept of Degree of Operating Leverage. I know that operating leverage is a firms fixed cost compared to its variable cost and the ratio determines how the effect of a change in sales will effect EBIT but how does that relate to operating leverage? I nderstand how DFL ratio is related to fixed expenses the firm incurs but I am trouble grasping the concept of DOL. I hope someone can explain. Thank you
With high operating leverage, a good chunk of sales will be used to cover fixed costs. That means that relative to low operating leverage, less is left in EBIT. Thus, for a given change in sales, the percent change in EBIT will be greater the higher the operating leverage.
Notice that DOL will be different at various levels of sales. The higher the sales, the lower the DOL. This is because at higher sales, less per unit goes toward fixed costs, and thus the percent change in EBIT will be lower for a given change in sales.
I was going to answer this question, but I see your status states you have passed Level 1 CFA.
This material is not in the LOS for Level 2 (well, not for 2012 material - maybe they will be mean and add it back to 2013), thus you don’t really need to learn it.
Were you asking this question just to pass time until you got your exam marks?
If so I am sure there is a thread somewhere in Analsyt Forum with the answer.
If not, I am still sure there is a thread with the answer - you probably won’t come accross this material again in your life.
I’m a credit analyst, and I use operating leverage quite often.
Fine, some people use it…
degree of operating leverage (DOL)
= %∆ in operating income / %∆ in # of units sold = Q(P-V) / Q(P-V) –F
where Q = quantity sold; P = price per unit; V = variable cost per unit; F = fixed cost per unit
If a business increases its fixed cost, degree of operating leverage will also increase. If you compare 2 similar companies holding everything else constant. The company with the higher DOL is a riskier business to operate than because of the increase fixed cost.
Thus if DOL = 5%…+/- 1% change in units sold will equal +/- 5% change in operating income
degree of financial leverage (DFL)
= %∆ in net income / %∆ in operating income
= Q(P-V)-F / Q(P-V) –F-C
where C = financial cost and net income = operating income - interest - taxes
Thus DFL of 2… for every 1% change in operating income, net income changes by 2% due to financial leverage
degree of total leverage (DTL) = DFL x DOL
= %∆ in net income/%∆ in # of units sold = Q(P-V) / Q(P-V) –F-C
If DTL = 4… 1% increase in units sold equal 4% increase in net income
About the formula and the relationship, I guess the above comments should suffice.
The essence is whenever in Finance, leverage comes into picture, it means that it is not good or bad for the project or company… By use of leverage youy are actually incresing the debt component which may be due to many factors ( low cost, ease of raising it) … but also the cost of increased exposure to risk ( risk of not being able to repay, commitments)…
In this case again the OL increases fixed cost but there is certain limit to which it can raise fixed cost after which the project or company will not get benefits or sustain to fund the increase in fixed costs… The effect of this leverage is that %change in sales leads to greater % change in EBIT…
If I am missing out something or misstating please correct …as I myself an amateur in finance…
That is correct NeverGiveUp.
Level 1 does not go too deep into the material. I would check the end of chapter readings on DOL but I don’t think they expect you to know more than that.