Correct Answer:
A. Contribution / EBIT
Operating leverage is a measure of how sensitive a company's operating income (EBIT) is to a change in sales revenue. It reflects the extent to which fixed costs are utilized in the production process. A higher degree of operating leverage means that a small change in sales can lead to a proportionally larger change in EBIT, due to the magnification effect of fixed costs.
- The correct formula for the Degree of Operating Leverage (DOL) is Contribution / EBIT (A). The contribution margin (Sales Revenue minus Variable Costs) represents the revenue available to cover fixed costs and contribute to profit. Dividing this by EBIT quantifies the leverage.
- EBIT / Sales (B) represents the operating profit margin, indicating how much operating profit is generated per dollar of sales, not operating leverage.
- Fixed cost / Contribution (C) is not the standard formula for operating leverage, although fixed costs are a critical component of the concept.
- Sales / EBIT (D) is the inverse of the operating profit margin and does not represent operating leverage.
Understanding operating leverage helps businesses assess risk and potential profitability changes with sales fluctuations.