Interpreting and measuring operating leverage

Lord, Richard A. Issues in Accounting Education. Sarasota: Fall 1995. Vol. 10, Iss. 2; pg. 317

MOST business majors study the concept of break-even analysis at some point in their
accounting training. Many of these students are also exposed to the notions of operating leverage
and degree of operating leverage in their courses on managerial accounting and finance. It is
often implicitly suggested that operating leverage is a simple measure of the extent to which a
firm is employing fixed costs in its production function. This paper explores two aspects of the
firm's degree of operating leverage.
First, the theoretical relationship between changes in a firm's operating characteristics (unit price,
level of output, unit variable cost, and fixed costs) and its degree of operating leverage is
developed. It is found that conventional measures of degree of operating leverage do not
necessarily rise as fixed costs increase accompanied by a decrease in unit variable costs, but that
changes in the degree of operating leverage are positively related to increases in cost, whether
fixed or variable. Even more interesting, it is found that (for a given level of demand) each firm
has a natural rate of substitution at which it can increase fixed costs while lowering variable costs
without any change in the degree of operating leverage or break-even point. In fact, it is possible
to find a firm taking on higher levels of fixed costs with lower unit variable costs and have its
degree of operating leverage and break-even point decrease.
The second area of concern is the difference between measures of degree of operating leverage
as they are computed in practice, as compared to how they appear in most textbooks. There are
two computational nuances to consider. One is the simple difference between point elasticities
and point-to-point elasticities. The other is the tendency of point-to-point measures of degree of
operating leverage to produce numerical results less than one for small changes in unit output.
This is of extreme importance for researchers attempting to employ degree of operating leverage
as a simple linear or curvilinear proxy for a firm's operating leverage.
The relationship between fixed and variable cost technology, operating leverage, and the breakeven point is first outlined. Then, a theoretical analysis of degree of operating leverage is
developed. Next, the empirical performance of the various methods to calculate the degree of
operating leverage are presented, and in the final section, conclusions are summarized.
RELATIONSHIP BETWEEN FIXED COST, VARIABLE COST, AND OPERATING
LEVERAGE
The principles of fixed and variable costs are usually introduced to students early-on in cost and
managerial accounting, as well as microeconomics courses. While these concepts are simple to
understand, practitioners know that they -- especially fixed costs -- are elusive in real life.

After exposure to the idea of fixed and variable costs, some students in managerial accounting
and finance are introduced to the concept of operating leverage. Characteristic is the statement
from Garrison and Noreen (1994, 295) that "If a company has high operating leverage (that is, a
high portion of fixed costs in relation to variable costs), then profits will be very sensitive to
changes in sales." Similar definitions can be found in managerial accounting texts by Hansen and
Mowen (1994, 350) and Hilton (1994, 339). They are also common in finance texts -- for
instance, the popular volume by Brigham (1994, 426). To demonstrate this relationship, authors
show a couple of hypothetical income statements. These examples usually leave the student
convinced that firms with high fixed costs and low variable costs will have high levels of
operating leverage.
Notice, however, that the word "portion" in Garrison and Noreen's definition makes the operating
leverage dependent on the level of the firm's rate of output, which, in turn, depends on quantity
demanded. For instance, imagine a firm with a production function involving a given (annual)
fixed cost and a per-unit variable cost. If it produced only one unit this year, it would clearly
have very high fixed costs relative to variable costs, hence it would have a high level of
operating leverage. As output begins to rise, however, the firm's level of operating leverage
would begin to fall. This definition of operating leverage depends as much (or more) on the
exogenous level of demand as it does on the endogenous fixed and variable cost technology the
firm has chosen to employ.
Most textbooks also present alternative measures to quantify the relationship between the
amounts of fixed cost and unit variable cost in a firm's production technology and the risks
associated with demand for the product. The most common and most simple is, of course, the
break-even point (BE). Cost accounting texts usually include a lengthy discussion of costvolume-profit (CVP) analysis. Many managerial accounting texts also feature a presentation of
degree of operating leverage (DOL). For instance, Garrison and Noreen (1994, 296) and Hansen
and Mowen (1994, 350) both include a discussion of DOL, while Hilton (1994) does not. In this
work, we will concentrate on the properties of DOL as a measure of the relative amounts of fixed
and unit variable costs employed by the firm in production (with occasional references to the
BE).
When a discussion of DOL is included in accounting texts, the most popular definition is:
DOL sub 1 =
(p - v)Q
/
(p - v)Q - F

, (1)
where p is the unit price of goods sold, v is the unit variable cost, F is the periodic fixed cost of
the firm, and Q is the unit output or quantity demanded for the period. From a practical point of
view, this presentation is not very useful, as the parameters necessary for the calculation are
usually unobservable.
A more workable alternative, presented by Brigham (1994, 440) in his finance text, which we
will dub DOL sub 2 is:
DOL sub 2 = % Delta EBIT / % Delta Q, (2)
where EBIT is the firm's earnings before interest and taxes ((p - v)Q - F). Again, since Q is often
unobservable to outside analysts, equation (2) is often presented as:
DOL sub 3 % Delta EBIT / % Delta Sales ($), (3)
where sales are pQ. Such definitions occur less frequently in the managerial accounting texts, but
they do occasionally appear. For instance, see Hansen and Mowen, (1994, 350) and Maher et al.
(1991, 917).
It is obvious from equations (2) and (3) that DOL is what an economist would call an elasticity
measure. As defined above, DOL sub 1 is a point estimate of the elasticity measure whereas DOL
sub 2 and DOL sub 3 are arc elasticities or estimates of the elasticity made from actual, observed
changes.
We wish to determine to what extent these elasticity measures of operating leverage tell us about
changes in the endogenous level of fixed and variable cost in the firm's production function. By
observing changes in the various measures of DOL, what can we predict about shifts in the
production function?
ESTIMATES OF DOL WITH OBSERVABLE & OPERATING PARAMETERS
In most textbook presentations, it is assumed that unit price (p), unit variable cost (v), and fixed
costs (F) are unchanging parameters and that DOL is a function of unit output (Q). Under these
conditions, equations (2) and (3) are interchangeable since, with prices given, the change in unit
sales and dollar sales are identical. The analysis implicitly assumes that p is determined in a
perfectly competitive economy and is not a function of Q and that there are no downward sloping
demand curves. If there were, the calculations would be much more complex.
Equation (1) is based on the (presumably observable) levels of three parameters (p, v, and F) and
the variable (Q). The reader can quickly confirm the relationship between the break-even point

and DOL, noting where Q > BE, then DOL sub 1 > 1, and if Q < BE, then DOL sub 1 < 0. This
relationship is obvious from the graphs usually presented in the CVP analyses of most
accounting texts explaining operating profit or loss as a function of units sold (see Horngren et
al. 1994, 64). Another, more informative graphical relationship between DOL sub 1 and Q
(assuming the parameters p, v, and F are given) is presented in chart 1, showing that DOL
converges to plus or minus infinity as output approaches the BE point. (All charts omitted)
Let's consider how the level of DOL sub 1 would change in response to changes in its various
subcomponents. First, it is obvious from chart 1 that DOL sub 1 decreases as the variable Q
increases (given the parameters p, v, and F). This result holds whether Q is above or below the
BE point (the one exception being the jump from negative to positive infinity as you "cross" the
BE point). To be precise, the partial derivative for DOL sub 1 , with respect to Q is:
deltaDOL sub 1 /deltaQ = -F(p - v)/
((p - v)Q - F) sup 2
. (4)
As long as (p-v) > 0, this derivative is negative.
Now let's consider what would happen if the parameters of the function change, which is, of
course, very possible in the real world. First, what if there were a change in price, assuming
constant v, F and Q? In this case,
deltaDOL sub 1 /deltap = -FQ/
((p - v)Q - F) sup 2
, (5)
then, DOL sub 1 decreases with increases in price. It should also be noted that where P < v, 0 <
DOL sub 1 < 1, a result that is impossible on chart 1, which was based on the assumption p > v.
The parameters of most interest are the fixed and variable costs. The partial derivatives in each
case are,
deltaDOL sub 1 /deltav = FQ/
((p - v)Q - F) sup 2
, (6)

and
deltaDOL sub 1 /de;taF = (p - v)Q/
((p - v)Q - F) sup 2
. (7)
These two derivatives imply that DOL sub 1 increases with an increase in either fixed or variable
cost (assuming p > v).
It is also interesting to note the interrelationships between these measures at any given level of
output. The measures deltaDOL sub 1 /deltap and deltaDOL sub 1 /deltav have exactly the same
magnitude but opposite signs. Also, the ratio between deltaDOL sub 1 /deltav and deltaDOL sub
1 /deltaF, is F/(p - v), which is equal to the BE point. Similarly, the ratio between deltaDOL sub 1
/deltav and deltaDOL sub 1 /deltaQ is -Q/(p - v) and that between deltaDOL sub 1 /deltaF and
DOL sub 1 /deltaQ is -F/(p - v).
Consider two firms, manufacturing the same product, where both sell their output for $8.00 per
unit, and both have annual demand for 200 units. Firm A employs a technology involving fixed
costs of $400 per year and variable costs of $4.00 per unit. Firm B, on the other hand, has a
variable cost of only $3.00 per unit, but has annual fixed cost of $500. Both of these firms have a
DOL sub 1 = 2, even though Firm B clearly uses a higher ratio of fixed costs to unit variable
costs in its production function.
Interestingly, these two different technologies have the same DOL sub 1 and BE point at every
level of output. There is, in fact, an associated family of fixed vs. variable cost production
functions that would all have the same DOL sub 1 at every level of output. This set of
technologies is linear in fixed cost vs. variable cost space (see chart 2). Technologies above and
to the right of the line have higher levels of DOL sub 1 than those on the line, and technologies
below and to the left have lower levels of DOL sub 1 (at a given level of demand). If fixed costs
are changed as a function of variable costs when a new production technology is introduced, the
slope of this line is,
deltaDOL/deltav = {
(pQ - vQ - F)(-Q)
(pQ - vQ)(-Q - deltaF/deltav)

}/
(pQ - vQ - F) sup 2
.
Setting deltaDOL/deltav = 0 and solving for deltaF/ deltav, deltaF/deltav =
(pQ - vQ - F)/(p - v)
- Q. Then, substituting DOL sub 1 back into the expression, deltaF/deltav = -Q(1- (1/DOL sub
1 )). When the firm substitutes fixed for variable cost at this rate, DOL sub 1 will remain constant
for a given level of output. If the firm adds new fixed costs at a higher rate than the
corresponding reduction in variable costs, DOL sub 1 will rise for a given level of demand. This
would be a shift from point A to point B on chart 2. These are the cases usually presented in
numerical examples of operating leverage, DOL or BE point. This gives students the impression
that these measures rise with an increase in the ratio between fixed cost and unit variable cost.
Notice, however, that it would be possible to shift from point A to point C, raising fixed costs and
lowering variable costs, yet DOL would fall at all levels of output.
ELASTICITY MEASURES OF DOL
Next, consider the arc elasticity measures of DOL represented by equations (2) and (3). First,
make the usual assumptions that price, fixed cost, and unit variable cost are constant and that
only the output is allowed to fluctuate. Consider a firm with a unit selling price of $8.00, unit
variable cost of $4.00 (p - v = $4.00), and fixed costs of $400 per year, implying a BE point of
100 units (these same initial conditions will be used in all subsequent examples).
Suppose that annual sales are at 97 units, (which is below the BE point), and that sales grow at
one percent per year. Results for Q, EBIT and each of the three estimates of DOL are presented
in table 1. (All table omitted) As predicted by equation (4), each DOL measure falls as Q
increases (with the exception of the jump over BE). Also, DOL never falls in the range between
zero and one. The relationship between the different DOLs is clear with DOL sub 2 and DOL sub
3 tracking DOL sub 1 exactly. This is not surprising, as these were the conditions under which
equations (2) and (3) were derived from equation (1).
It is necessary to point out a potential problem in the calculation of DOL sub 2 and DOL sub 3 .
As stated above, equation (1) is a point estimate of the DOL, while equations (2) and (3) are
based on actual ex post changes in the variables. Normally, formulas for percentage change are
presented as either,
% Delta Q = (Q sub 2 - Q sub 1 )/Q sub 1 , (8)

or,
% Delta Q = (Q sub 2 - Q sub 1 )/
(Q sub 1 + Q sub 2 )/2
. (9)
If the percentage changes used to calculate DOL sub 2 and DOL sub 3 were estimated by
equation (8), DOL sub 2 and DOL sub 3 would appear to lag DOL sub 1 by one period. If
equation (9) were employed to estimate the percentage changes used to calculate DOL sub 2 and
DOL sub 3 , the estimates would be an "average" of the current and preceding estimates of DOL
sub 1 . Therefore, care must be taken to line up the estimated percentage changes used in
calculating DOL sub 2 and DOL sub 3 with the point estimate of elasticity. This can be done, in
this example, by using the final value of the variables (where the point estimate is made) as the
denominator of the fraction,
% Delta Q = (Q sub 2 - Q sub 1 )/Q sub 2 . (10)
The results of the calculations of DOL sub 2 and DOL sub 3 in table 1 show that estimating the
percentage changes using equation (10) will align all the estimates of DOL.
Dugan and Shriver (1992) conducted an empirical study of elasticity-based measures of DOL
using accounting data. One of their efficiency tests of a measure of DOL was the percentage of
results greater than one. This follows a suggestion by O'Brien and Vanderheiden (1987).
Assuming most firms operate above their BE point, this seems to be a reasonable approach. The
very notion of this test, however, suggests that, in practice, estimates of DOL sub 2 and DOL sub
3 tend to produce a considerable number of observations less than one (which, according to the
logic in the last section, would imply a unit sales price less than variable cost) and even less than
zero (which implies the firm is operating below the BE point). Clearly, in practice, the estimates
of DOL sub 2 and DOL sub 3 over time do not behave as anticipated in chart 1 and table 1. This
is because the parameters, p, v, and F, are not constant. However, our earlier estimates of partial
derivatives (in equations (5), (6), and (7)) should give us some insight into the sensitivity of
changes in estimates of DOL sub 2 and DOL sub 3 to changes in the parameters.
Therefore, we will consider, analytically, the cases where these parameters are allowed to
fluctuate. Notice that in equations (2) and (3), we cannot hold output constant, as this would
result in a value of zero in the denominator. Therefore, we cannot conduct a true sensitivity
analysis of the impact of the changes in parameters on DOL sub 2 and DOL sub 3 in isolation.
For our examples, we will assume base levels for the parameters of p = $8.00, v = $4.00, and F =
$400 (the initial BE = 100 units). We will then consider cases with values above and below the

base level for each parameter in turn. Since unit output must also vary in order to calculate a
DOL sub 2 or DOL sub 3 , we will consider values of output around an initial base level of 110
units (in the profitable region of output). This base level of unit output was chosen for two
reasons. First, it is near the BE point, so changes in the level of DOL will be large for a change in
the variable or parameter (this would arguably be the area of most interest to a firm's manager).
Second, according to equation (4), this also happens to be the point at which deltaDOL/deltaQ =
-1. This should make it a bit more convenient to distinguish the impact of a change in output
from the impact of the change in the parameter of interest. Results for the cases where unit
variable costs are allowed to fluctuate along with unit output are presented in tables 2 and 3. The
levels of DOL sub 1 are presented in table 2 and the levels of DOL sub 2 and DOL sub 3 are
shown in table 3 (in this case, since unit price is constant, these values are identical). In table 2, it
is possible to see the impacts of changes in unit output and unit variable cost in isolation. In the
column with v = 4.00, we can observe the impact of changes in output on DOL sub 1 . Notice
that as Q decreases below the base level of 110 units, the levels of DOL sub 1 increase by
slightly more than two for each two-unit decrease in output. Also, as output increases above the
base level by units of two, DOL sub 1 decreases by increments of slightly less than two. As noted
earlier, deltaDOL sub 1 /deltaQ = -1. In this case, the slight discrepancies are, of course, based on
the convexity of the curve (as seen in chart 1).
In the row with Q - 110, we can see the impact of changes in unit variable cost in isolation. At
the initial levels of output deltaDOL sub 1 /deltav = 27.5. Since variable cost is changing in
increments of 2 cents, one would theoretically anticipate changes in the level of DOL sub 1 by
0.55 (27.5 x .02) across each column. Note that as unit variable cost increases above $4.00, the
changes in DOL are slightly greater than 0.55, and as v decreases below $4.00, the changes in
DOL sub 1 are slightly less than 0.55 (again, this is due to the convexity in the relationship
between v and DOL sub 1 ). Also note that the values of DOL sub 1 rise steadily along each row
and column as the level of unit output falls and the level of unit variable cost rises.
The values for DOL sub 2 and DOL sub 3 , in table 3, were calculated by taking the percentage
change from the initial base position (p 8.00, v - 4.00, F - 400, Q = 110, and DOL sub 1 = 11.00)
to the new level of output and unit variable cost using equation (10). As stated above, it is not
possible to calculate levels of DOL sub 2 and DOL sub 3 in the case where output does not
change. Also, notice that in the column with v = 4.00, the results in table 2 and table 3 are
identical. This is, of course, the same result seen in table 1.
What is most interesting is to observe the differences between table 2 and table 3 for the results
in the quadrants off the center row and column. In the extreme corner of each northern quadrant
(lower unit output), the values of DOL sub 1 and DOL sub 2 are both higher than the initial level
of DOL sub 1 = 11.00. In the northeastern quadrant, values of DOL sub 2 are greater than
corresponding values of DOL sub 1 . However, in the northwestern quadrant, values of DOL sub
2 are less than DOL sub 1 . In the southern quadrants, we observe the opposite conditions: values

are below DOL sub 1 = 11.00, while DOL sub 2 > DOL sub 1 in the southwestern quadrant and
DOL sub 2 < DOL sub 1 in the southeastern quadrant.
The other notable feature of table 3 is that, if one looks down the columns, as unit output rises,
DOL sub 2 does not steadily fall. There is an obvious "ridge" in the level of DOL sub 2 , where it
falls then rises then begins to fall again. Most of these dips appear near the center row, but in the
column with v - 4.04, it can be seen further down the column.
These two differences in the outcomes are caused by two separate computational nuances. The
source of the first bias is again an arc elasticity problem. Both measures of DOL are based on
equation (2), which can be rewritten as: DOL =
(EBIT sub 2 - EBIT sub 1 )/EBIT sub 2 /(Q sub 2 -Q sub 1
/Q sub 2
, but in calculating DOL sub 1 , it is implicitly assumed that p sub 1 , v sub 1 , and F sub 1 are
equal to p sub 2 , v sub 2 , and F sub 2 throughout:
(equation 11 and 12 omitted)
In tables 2 and 3, p sub 2 = p sub 1 and F sub 2 = F sub 1 , but v sub 2 -= v sub 1 . For instance,
in the northeastern quadrant, v sub 2 > v sub 1 -- therefore, DOL sub 2 > DOL sub 1 . Similar
reasoning, of course, explains the biases in the distant corners of the other three quadrants.
The second flaw, the existence of "a valley and a ridge" in the data near the row associated with
the base level of output (Q = 110), is also due to a problem involved in estimations of elasticity
from point-to-point. Notice that very small changes in unit output create relatively large changes
in EBIT as they are leveraged in the numerator, since they are multiplied by the operating
margin. In table 3, these effects are hidden, since at an output level of Q = 110, we are so near
the BE point that small changes in output cause relatively large changes in DOL sub 2 . In table
4, we see a case featuring much smaller changes in unit output, and here the very large positive
and negative levels of DOL sub 2 associated with small changes in unit output are clear. It is also
important to keep in mind that this problem can be quite serious at levels of output far from the
BE point, as the level of sensitivity to changes in unit output is even lower. Results for
calculations of DOL sub 2 for the area around an initial output level of 210 units are shown in
table 5. Here the negative results for DOL sub 2 are evident. Also, notice that for several
observations, 0 < DOL sub 2 < 1. According to standard theory, this should occur in cases where
p < v, which is, of course, unlikely, but such results will obviously be quite common when
equations (2) or (3) are employed to calculate DOL.

The estimates for levels of DOL sub 1 and DOL sub 2 associated with changes in unit output and
fixed costs are summarized in tables 6 and 7 respectively. At the initial conditions, the elasticity
deltaDOL sub 1 /deltaF = 0.275, which means that changes of $2.00 in the fixed costs should
cause changes of approximately 0.55 in the level of DOL sub 1 (notice, as stated above, that
DOL sub 1 /deltav
/
deltaDOL sub 1 /deltaF
= F/(p - v)). The results are clearly very close to those for changes in variable cost summarized in
tables 2 and 3. As expected, rising levels of DOL sub 1 are associated with falling levels of
output and rising costs. We also notice the same biases in the estimates of DOL sub 2 , where
small changes in output cause extreme results, and also the arc estimation problems for values of
DOL sub 2 associated with larger changes in output.
Results for the levels of DOL sub 1 , DOL sub 2 , and DOL sub 3 , when both unit output and
unit price change, are presented in tables 8, 9, and 10 respectively. Again, the familiar patterns
occur. In this case, DOL sub 1 increases with decreases in unit price. In fact, as discussed above,
deltaDOL sub 1 / deltap = -deltaDOL sub 1 /deltav, and comparison reveals that tables 8 and 9
are mirror images of tables 2 and 3. The results for both DOL sub 2 and DOL sub 3 reveal the
existence of extreme values for small changes in unit output. Both are also biased by the arc
elasticity problem for larger changes in unit output. An interesting feature of table 10 is that the
results from elasticity DOL sub 3 are closer to those for DOL sub 1 than are estimates of DOL
sub 2 . This helps reduce this bias to an extent, as DOL sub 3 is, in fact, the most commonly used
method in practice.