Degree of Operating Leverage (DOL) Lecture Notes

Introduction to Leverage

• Definition: A lever is a tool that multiplies power, allowing modest amounts of effort to move large objects (e.g., wheelbarrow).
• Context: In finance, we discuss Degree of Operating Leverage (DOL) which measures sensitivity of net income to changes in sales.

Understanding DOL

• DOL indicates how a percentage change in sales will affect net operating income (NOI).
• Higher DOL: A small change in sales leads to a larger change in profit (bottom line).

Example Companies

• Lean Company: Lower fixed costs, relies on labor.
• Big Company: Higher fixed costs, uses automation.
• Sales for both companies: $100,000
• Net Operating Income (NOI) for both: $10,000

DOL Calculation

• Formula: DOL = (Contribution Margin) / (Net Operating Income)
  • Contribution Margin = Sales - Variable Expenses
• Lean Company DOL Calculation:
  • DOL = 4
• Big Company DOL Calculation:
  • DOL = 7

Impact of Sales Increase

• Sales Increase of 10%:
  • Big Company: Profits rise to $17,000 (70% increase in profit)
  • Lean Company: Profits rise to $14,000 (40% increase in profit)
• Conclusion: Higher DOL results in greater sensitivity of profit to sales increases.

DOL Variability

• DOL is not constant as a company grows. It changes at different sales levels.
• Example Calculation:
  • Company with 40% contribution margin:
    • Sales = $75,000, Variable Expenses = $45,000
    • Contribution Margin = $30,000
    • Fixed Costs = $30,000
    • DOL changes as sales increase:
      • After $5,000 increase: DOL = 16
      • After increasing sales from $80,000 to $100,000: DOL = 4
      • From $100,000 to $150,000: DOL = 2
      • From $150,000 to $175,000: DOL = 1.25
• Observation: As sales move away from break-even point, DOL decreases.

Importance of Break-Even Point

• Managers aim to reach break-even to maximize the effect on NOI from increases in sales.

Conclusion

• Encouragement to engage with additional resources at foreheadlectures.com for further study, including MCQs.
• Investment in accounting education (CPA preparation) is emphasized.
• Final Note: Study hard and stay safe.