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How to Calculate the Degree of Operating Leverage: Formula & Example

Instructor: Adam Gifford

Adam holds an MBA and a MS in Human Resources

In this lesson we'll discuss degree of operating leverage, an important tool that is used by financial analysts to gauge the health of a company. We'll define the concept, discuss the formula, and solve a real-world example.

Measuring the Change

The owners of Drain Brothers Plumbing want to know how well their business is doing. They know that there are a number of different ways to measure the health of a business. One of the more common methods is to calculate the degree of operating leverage. The degree of operating leverage measures the volatility level of a company's operating income. Now, in order to understand that definition, you'll need to understand the terms contained in the definition.

Volatility is a measure of change that occurs in a certain variable.

Operating income is defined as a company's sales minus expenses with the amount paid in interest and the amount paid in taxes added back in to the final number. It is also referred to as ''income before interest and taxes''.

There are a few different methods that are used to calculate degree of operating leverage. The owner of Drain Brothers Plumbing have decided to use the operating income method because the variables that are used in the calculation are readily available using only their basic accounting reports. The other methods require a deeper understanding of a the company's costs, debts and ownership.

Determining the Variables

In order to understand the formula used to calculate the degree of operating leverage you will need to determine 2 variables:

  • The % change in operating income - To calculate this you will need to have the operating income for 2 consecutive years.
  • The % change in sales -To calculate this you will need to have the sales for the same 2 consecutive years that you have for operating income.

Once you have that data you will need to determine the percent change for each of the variables.

The formula to determine percent change for operating income is as follows:

((Current Year Operating Income - Previous Year Operating Income) / Previous Year Operating Income) * 100

The formula to determine percent change for sales is as follows:

((Current Year Sales - Previous Year Sales) / Previous Year Sales) * 100

Calculating the Variables

Let's calculate the percent change in operating income and percent change in sales for Drain Brothers Plumbing using the following data:

This year's operating income - $110,000

Last year's operating income - $100,000

This year's sales - $900,000

Last year's sales - $800,000

% Change in Operating Income = ((Current Year Operating Income - Previous Year Operating Income) / Previous Year Operating Income) * 100

% Change in Operating Income = (($110,000 - $100,000) / $100,000) * 100

% Change in Operating Income = ($10,000 / $100,000) * 100

% Change in Operating Income = .1 * 100

% Change in Operating Income = 10%

% Change in Sales = ((Current Year Sales - Previous Year Sales) / Previous Year Sales) * 100

% Change in Sales = (($900,000 - $800,000) / $800,000) * 100

% Change in Sales = ($100,000 / $800,000) * 100

% Change in Sales = .125 * 100

% Change in Sales = 12.5%

Calculating the Degree of Operating Leverage

Once you have determined the percent change in operating income and the percent change in sales, you can now use those numbers to calculate the degree of operating leverage. The formula for the calculation is:

Degree of Operating Leverage = % Change in Operating Income / % Change in Sales

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