Degree of Operating Leverage
Degree of operating leverage helps to identify the effectiveness of the operating leverage in the company’s earning. It is calculated before the calculation of tax and interest. It calculates the variation of the company’s earning because of the operating leverage. It can also be termed as the ratio of the percentage change in EBIT to the change in sales. EBIT is nothing but the earning of the company before the interest and the tax are deducted from the profit. Operating leverage is nothing but the influence of each sale on the profit margin as a whole
Degree of operating leverage=% change in EBIT/ change in sales
Where earning before interest and tax is denoted by EBIT.
If there is more sales and the influence of each sales is less on the gross margin then it is said to be very low leveraged, whereas if the sales is less but the gross margin is more then it is said to be highly leveraged. The business with higher portion of fixed cost and lesser portion of variable cost is said to be highly leveraged. While the business with higher portion of variable cost and lesser portion of fixed cost then it is said to be operating with less operating leverage.
Investor must invest in business with lower operational leverage. The businesses with lower operational leverage are said to be less risky. Investor must avoid business with higher operational leverage. The businesses with higher operational leverage are more risky. In case of business with higher operational leverage a small error in calculation will lead to a huge loss as the influence of error will be more, wherein business with less operational leverage the margin of error can be more. The loss incurred in these businesses with less as the influence of the error will be less.
The investor use degree of operating leverage as a tool to identify whether to make investment on a particular business. Investor will make investment if the operating leverage is low for a business and refrain from doing investment if the degree operating leverage is high. There is exception as well, because the business with high operating leverage might at times yield a higher profit.