This video discusses the concept of “Degree of Operating Leverage”. In the next class, we will discuss the “Degree of Financial Leverage”. The following is a part of the transcript. The video requires flash 8 or higher.

A simplified Income Statement is consisted of the following parts:

Gross Sales (Quantity X Price, QP)

-          Total Variable Cost (TVC = Q X VC)

-          Fixed Cost (FC)

= Earnings Before Interest and Tax (EBIT)

Degree of Operating Leverage measures the percentage change of EBIT for every percentage change of quantity sold:

DOL = %DEBIT /%DQ

It can be derived that,

DOL = Q(P-VC)/(Q(P-VC)-FC)

This is an important measurement of the operating risk of a company. When the quantity sold is still low, it means the FC is larger or close the TVC, a fluctuation in the quantity sold will have big impact on the EBIT due to large DOL .This means that if the economic environment is bad, the EBIT of the company may suffer significantly compare to the companies with lower DOL.

Please refer to the video for example.