Degree of operating leverage measures the sensitivity of operating income earnings before income and taxes (EBIT) to changes in unit sales. With this in mind, what would happen to the DOL if all costs are fixed? Variable?
Fixed costs are those which remain stable throughout the operational cycle. Variable costs are those which will vary in relation to sales performance. For example, fixed costs relate to rent, utilities, salaries, insurance, and the like. Variable costs relate to cost of goods sold, commissions, transportation, advertising, and so on.
Essentially then, if sales were to increase, the degree of operating leverage (DOL) would increase because all costs would have stabilized. If Sales are currently $1 million, with fixed costs of $500,000, then we have EBIT of $500,000, or a 2:1 ratio (for every dollar of sales incurred, there will be 50 cents in EBIT). Now if sales increase to $2 million, with the same fixed costs, then the ratio is 1.33:1 (creating a situation wherein for every dollar of sales, there will be a corresponding EBIT of $.33). The result is that while EBIT will increase, the DOL will increase due to the incremental change in DOL, which results in gaining EBIT due to the fixed nature of the cost structure noted as the following:
DOL = % change in EBIT/%change in Sales
Now if the same situation were to apply to variable costs, then we would notice a shift in the relationship because we now have a varying degree of costs versus sales --- as sales increase, so do costs. The result would be a decrease in operating leverage due to the fact that EBIT would reduce in value, leading to a reduction in operating leverage due to the higher cost structure as it relates to the increase in sales.
It can be seen as follows:
An illustration of how fixed and variable costs affect the break even point and the degree of operating leverage for a business.