Degree of operating leverage is a concept which is used to calculate the effect of change in earnings of the company due to the change in sales of the company. Given below is the degree of operating leverage formula –
Percentage change in EBIT/Percentage change in sales
It can better explained with the help of an example, suppose a firm has sales of $50000 and Earning before interest and tax for the firm is $5000, now if the sales of the company increase to $100000 and its EBIT increases to $15000 then degree of operating leverage will be 2 which is calculated as under
Percentage change in EBIT is calculated as 15000-5000/5000 = 200%
Percentage change in sales is calculated as 100000-50000/50000 = 100%
Now putting the figures into the above formula we will get the figure of 2 (200%/100%)
The above figure indicates that whenever there is increase in the sales of the company then the earnings before interest and tax of the firm will increase 2 times more. Hence it can be said the higher the degree of operating leverage the better it is for the company.