Operating leverage for non-finance managers

I was asked by a few hospitality colleagues to explain Operating Leverage to non finance managers. I have attempted to put together a simple overview of this concept. It is of importance for managers to understand both OL and DOL so that they can continue to have meaningful conversations with their CFOs and Finance Experts.

Operating leverage is a measure of how much a company's operating income changes in response to a change in its sales revenue. It indicates the level of fixed costs in a company's cost structure.

The formula for operating leverage is:

Operating Leverage = Contribution Margin / Operating Income

where Contribution Margin = Sales - Variable Costs

Degree of operating leverage (DOL) is a measure of the sensitivity of a company's operating income to a change in its sales revenue. It measures the percentage change in operating income that results from a 1% change in sales revenue.

The formula for degree of operating leverage is:

DOL = Percentage Change in Operating Income / Percentage Change in Sales Revenue

Let's illustrate this with an example:

Suppose Company A has annual sales of $1,000,000 and incurs variable costs of $600,000. Its fixed costs are $200,000, and its operating income is $200,000.

Contribution Margin = $1,000,000 - $600,000 = $400,000

Operating Leverage = $400,000 / $200,000 = 2

Now, suppose Company A increases its sales revenue by 10%.

New Sales Revenue = $1,100,000

New Contribution Margin = $1,100,000 - $600,000 = $500,000

New Operating Income = $500,000 - $200,000 = $300,000

Percentage Change in Operating Income = ($300,000 - $200,000) / $200,000 = 50%

Percentage Change in Sales Revenue = ($1,100,000 - $1,000,000) / $1,000,000 = 10%

DOL = 50% / 10% = 5

This means that for every 1% increase in sales revenue, the operating income of Company A will increase by 5%.