How to use the operating leverage calculator
- Revenue for a year, or another period you use consistently.
- Variable costs: costs that move with sales, such as materials, shipping, commissions and payment fees.
- Fixed operating costs: rent, salaried staff, insurance, software and depreciation, which stay the same when sales change.
- Interest expense on all borrowing, for the financial leverage.
- Tax rate and shares outstanding turn pre-tax profit into earnings per share. With a flat tax rate they do not change any of the leverage ratios; for a private business, any share count works.
The results show the three leverage ratios and the profit figures behind them. The table and chart show what a revenue change of up to 20% either way does to operating profit and EPS.
The formulas
EBIT = Contribution margin − Fixed operating costs
EBT = EBIT − Interest expense
DFL = EBIT ÷ EBT
DTL = DOL × DFL = Contribution margin ÷ EBTDOL is the % change in EBIT for a 1% change in sales; DFL the % change in EPS for a 1% change in EBIT; DTL the % change in EPS for a 1% change in sales. They are exact as long as prices, variable cost per unit, fixed costs, interest and the tax rate stay the same.
A worked example
Company D has $2,000,000 of revenue, $1,200,000 of variable costs, $500,000 of fixed operating costs and $100,000 of interest.
The contribution margin is $800,000 and operating profit (EBIT) is $300,000, so the DOL is 2.67×. After interest, pre-tax profit is $200,000, giving a DFL of 1.50×. Together they make a DTL of 4.00×.
If revenue rises 10%, operating profit rises 26.7% and earnings per share rise 40.0%, from $1.58. If revenue falls 20%, EPS falls -80.0%.
Why high fixed costs mean high operating leverage
Fixed costs do not shrink when sales fall, and they do not grow when sales rise. So when a large share of costs is fixed, every extra dollar of sales is mostly profit, and every lost dollar is mostly lost profit.
Compare Company D with a business that has the same revenue and the same $300,000 of operating profit but a different cost structure: $1,600,000 of variable costs and only $100,000 of fixed costs, for example because it outsources production instead of running its own plant.
| Company D (high fixed costs) | Flexible business | |
|---|---|---|
| Fixed operating costs | $500,000 | $100,000 |
| Contribution margin ratio | 40.0% | 20.0% |
| DOL | 2.67× | 1.33× |
| EBIT change if sales rise 10% | +26.7% | +13.3% |
| EBIT change if sales fall 10% | -26.7% | -13.3% |
| Break-even revenue | $1,250,000 | $500,000 |
Today both earn the same profit. In a good year Company D pulls ahead quickly; in a bad year it falls much further, and it reaches break-even at a far higher sales level. Software, airlines, hotels and manufacturers with expensive plants tend to have high operating leverage; distributors, staffing firms and businesses that pay mainly commissions tend to have low operating leverage.
Adding financial leverage
Debt adds a second fixed cost, interest, below operating profit. Without Company D’s $100,000 of interest, DFL would be 1.00× and DTL would equal the DOL of 2.67×. With it, DTL rises to 4.00×: a 1% change in sales moves earnings per share about 4.0%. A business with high operating leverage that also borrows heavily stacks one amplifier on another, which is why lenders look closely at both.
What this calculator does not include
The ratios describe one point in time and assume a straight line: variable costs stay a fixed share of revenue and fixed costs stay fixed. Over larger changes this breaks down, because fixed costs step up as a business grows and can be cut in a long downturn. The tax model is a flat rate on positive profit, so with a pre-tax loss the EPS figures in the table no longer follow DTL exactly. It also ignores changes in the share count from new issues or buybacks.