Business Risk and the Degree of Operating Leverage

Business Risk and the Degree of Operating Leverage | CFA Level I Corporate Issuers

Welcome back! In this lesson, we’ll learn about business risk and its components, and how to calculate a firm’s degree of operating leverage. Let’s bring back our example of Noke from our last lesson to understand business risk better.

Understanding Business Risk and Its Components

Firstly, business risk refers to the risk associated with a firm’s operating income or EBIT. EBIT can vary significantly, which poses a substantial risk to the company.

Since EBIT is the result of the firm’s sales and the expenditures necessary to produce the sales, these two are the main components of business risk:

Calculating the Degree of Operating Leverage (DOL)

To measure the level of operating risk of a company, we can estimate the degree of operating leverage (DOL) of the company. This measure is the sensitivity of a firm’s EBIT to its sales and is defined by the ratio of the percentage change in operating income to the percentage change in units sold.

For example, a ratio of 3.0 means that for every 1% change in the number of units sold, the operating income changes by 3%. So if the number of units increases by 5%, the operating income should increase by 15%.

To calculate DOL, use this formula:

DOL = (Q * (P – V)) / (Q * (P – V) – F)

Where Q is the quantity of units sold, P is the sale price per unit, V is the variable cost per unit, and F is the fixed operating costs. Note that this should not include any fixed financing cost, as we are only interested in the operating leverage at this stage.

However, you’ll notice that you cannot calculate DOL without knowing the quantity of units sold. The DOL of a firm is not constant and depends on the quantity of units sold or the level of production the company is at. If Noke is selling 1,000 units per month, its DOL will be 1000(10-2) / [(1000(10-2) – 5000] = 2.67.

EXAMPLE

If Noke’s number of units sold is 500, what is the DOL at this level of production?

DOL = 500(10-2) / [(500(10-2) – 5000] = -4.0

If you got -4, you are correct! Operating income at this level is negative, so the change in operating income should be in the opposite sign as the change in sales.

Degree of Operating Leverage in Different Forms

If we multiply the number of units in the DOL formula, the formula can be expressed in this different form:

DOL = (S – TVC) / (S – TVC – F)

Where S is the sales or revenue and TVC is the total variable costs. Note that in this form, the denominator is operating earnings or EBIT.

Calculating EBIT with DOL

EXAMPLE

The income statement for Adodos Corp for the past year is summarised in the table below. The company expects sales to increase by 15% for this year. What is the amount of EBIT the company can expect for the year?

Sales$120,000
Total Variable Costs$72,000
Fixed Operating Costs$18,000

Since we are not given unit sales, the first formula is not suitable for this question. We shall use the second formula to calculate DOL. Plug in the figures, where sales are $120,000, total variable cost is $72,000, and fixed operating cost is $18,000. Take special note not to include any fixed financing costs like interest.

DOL = (S – TVC) / (S – TVC – F) = (120k – 72k) / (120k – 72k – 18k) = 1.6

The percentage change in EBIT is the percentage change in sales times the DOL.
% change in EBIT = % change in sales x DOL = = +15% x 1.6 = +24%  

EBIT this year = 30k x 1.24 = $37,200  

Therefore, the amount of EBIT Adodos can expect for the year is $37,200.

And that concludes this lesson, where we learned business risk, sales risk, operating risks, and how to calculate the degree of operating leverage. Up next, we shall learn financial risk and how to calculate the degree of financial leverage. See you soon!

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