Operating Leverage (3)
Posted on May 21, 2009 - Filed Under Finance
Operating leverage is measured by the degree of operating leverage (DOL), which at any volume is calculated by dividing the total contribution margin by earnings before interest and taxes (EBIT), which for not-for-profit businesses is merely profit plus any interest expense. At a volume of 75,000 visits, Atlanta Clinic’s degree of operating leverage is $5,386,500 / $419,038 = 12.85. (We have no information regarding the clinic’s interest expense, so we are simply using its expected profit.) The DOL indicates how much
profit will change for each 1-percent change in volume. Thus, each 1-percent change in volume produces a 12.85 percent change in profit, so a 10 percent increase in volume results in a 10% × 12.85 = 128.5% increase in profit. Note, however, that the DOL changes with volume, so the 12.85 DOL calculated here is applicable only to a starting volume of 75,000 visits.
Cost structures differ widely among industries and among organizations within a given industry. The DOL is greatest in health services organizations with a large proportion of fixed costs and, consequently, a low
proportion of variable costs. The end result is a high contribution margin, which contributes to a high DOL. In economics terminology, high-DOL businesses are said to have economies of scale because higher volumes lead to lower per unit total costs. In such businesses, a small increase in revenue produces a relatively large increase in profit. However, high DOL businesses have relatively high breakeven points, which increase the risk of losses. Also, operating leverage is a double-edged sword: High DOL businesses suffer large profit declines, and potentially large losses, if volume falls.
Taken From : HEALTHCARE FINANCE
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