Question

What does Degree of Operating Leverage really mean? What does it mean to take the contribution margin and divide it by the NI. If the D. O. L was 7 does that mean that for every dollar in sales you are gaining a contribution of 7. I'm a little confused?

Answer 1

DOL (Degree of Operating Leverage)

It is level of operating risk that company has and operating risks is caused namely by operating costs .i.e Variable costs & fixed costs

DOL = Contribution margin / Net Income

Fixed costs do not change with level of production

Contribution margin = Sales - variable costs

Net income = Sales - variable costs-Fixed costs

A company with high DOL is at a greater operating risk and has a high fixed costs

If DOL is 7 it means for every 7 contribution earned you only get 1 as Net Income so it means for every 7 earned 6 is consumed by Fixed costs so the organisation is at a very high risk as Fixed costs commitment is very high for the company.