The degree of operating leverage calculates the proportional change in operating income that is caused by a percentage change in sales. This concept is used to evaluate the cost structure of a business, not including the costs of financing and taxes. For example, an entity with a high proportion of fixed costs will produce an unusually large (and positive) change in operating income if sales increase, since most of the costs incurred in the production process are fixed within a range of unit volumes. In this situation, management should guard against a reduction in sales, since this could trigger a steep decline in operating income. Conversely, the degree of operating leverage would be reduced when there is a high proportion of variable costs to fixed costs, since in this case most costs must be incurred every time a unit is produced.
There is considered to be high operating leverage when a change in sales triggers an even larger change in operating income.
The formula for the degree of operating leverage is to divide the change in operating income by the change in sales. The calculation is:
Change in operating income ÷ Change in sales = Degree of operating leverage
For example, a company has a high fixed cost structure, so its operating income will increase by 12% for every 10% change in sales. This results in a 1.2x degree of operating leverage.
The main concern with using the degree of operating leverage is that the derived proportion of sales only works within a limited range of sales. If sales increase beyond this range, a business will likely exceed its production capacity, and so must invest in additional capital assets, which will further increase its fixed cost structure. Conversely, if sales decline, management may be tempted to eliminate some capacity, which will reduce fixed costs and therefore the positive effects of the degree of operating leverage.
When a publicly held company has a high degree of operating leverage, its operating income will vary significantly over time, which tends to result in a more highly variable stock price.