Principles of Managerial Finance

EXAMPLE Using the data for Cheryl’s Posters (sale price,P$10 per unit; variable operating

cost,VC$5 per unit; fixed operating cost,FC$2,500), Figure 12.2 presents

the operating breakeven graph originally shown in Figure 12.1. The additional

notations on the graph indicate that as the firm’s sales increase from 1,000 to

1,500 units (Q 1 toQ 2 ), its EBIT increases from $2,500 to $5,000 (EBIT 1 to

EBIT 2 ). In other words, a 50% increase in sales (1,000 to 1,500 units) results in a

100% increase in EBIT ($2,500 to $5,000). Table 12.4 includes the data for Fig-

ure 12.2 as well as relevant data for a 500-unit sales level. We can illustrate two

cases using the 1,000-unit sales level as a reference point.

Case 1 A 50% increasein sales (from 1,000 to 1,500 units) results in a

100% increasein earnings before interest and taxes (from $2,500

to $5,000).

Case 2 A50%decreasein sales (from 1,000 to 500 units) results in a 100%

decreasein earnings before interest and taxes (from $2,500 to $0).

From the preceding example, we see that operating leverage works in both

directions.When a firm has fixed operating costs, operating leverage is present.

An increase in sales results in a more-than-proportional increase in EBIT; a

decrease in sales results in a more-than-proportional decrease in EBIT.

Measuring the Degree of Operating Leverage (DOL)

The degree of operating leverage (DOL)is the numerical measure of the firm’s

operating leverage. It can be derived using the following equation:^4

DOL  (12.4)

Percentage change in EBIT



Percentage change in sales

CHAPTER 12 Leverage and Capital Structure 513

degree of operating leverage
(DOL)
The numerical measure of the
firm’s operating leverage.

TABLE 12.4 The EBIT for Various Sales Levels

Case 2 Case 1

50% 50%

Sales (in units) 500 1,000 1,500

Sales revenuea $5,000 $10,000 $15,000

Less: Variable operating costsb 2,500 5,000 7,500

Less: Fixed operating costs  (^2) , (^5)  (^0)  (^0)   (^2) , (^5)  (^0)  (^0)   (^2) , (^5)  (^0)  (^0) 
Earnings before interest and taxes (EBIT) $ 0 $ 2,500 $ 5,000
100% 100%
aSales revenue$10/unitsales in units.
bVariable operating costs$5/unitsales in units.

4. The degree of operating leverage also depends on the base level of sales used as a point of reference. The closer the
   base sales level used is to the operating breakeven point, the greater the operating leverage. Comparison of the
   degree of operating leverage of two firms is valid only when the same base level of sales is used for both firms.