Degree of Operating Leverage

Companies with high fixed costs, such as factories, airlines and software developers, have high operating leverage. Once fixed costs are covered, each extra sale adds a large amount to profit. When sales fall, profit drops quickly.

DOL can be calculated as contribution margin divided by operating profit. For example, a company with a contribution margin of 400,000 and operating profit of 100,000 has a DOL of 4. A 10% increase in sales would raise operating profit by about 40%, and a 10% fall would cut it by about 40%.

DOL is highest when a company is just above its break-even point, and falls as sales and profit rise further.

Operating leverage is a double-edged sword. It magnifies gains in good times and losses in bad times. Understanding it helps managers plan for downturns, decide whether to convert fixed costs into variable ones, for example by outsourcing, and judge how much debt the business can safely carry.