 Hello and welcome to this session in which we would look at the degree of operating leverage or DOL. Now what is a leverage or what is a lever? Simply put, a lever is a tool for multiplying, for giving you more power. Simply put, a modest amount of power can move a massive object. Think of a wheelbarrow. Well, a wheelbarrow can help you because you can lever it to move a massive object. You cannot move yourself and this is what a lever is. But we're talking here about the degree of operating leverage. When the company operate, how sensitive is net income or net operating income to a giving percentage change in sales in sales? Simply put, when your when your top line, sales changes, how is that going to affect your profit, your bottom line? What is the change? What's the effect? How sensitive is your bottom line to that effect? A higher operating leverage means a small change would lead to a higher effect on profit if you have a high degree of operating leverage. Now the best way to illustrate this is to actually look at an example to show you what it means from a numbers perspective. We're going to be working with the same company that I worked with earlier when we talked about cost structure and that's Lean Company and Big Company. Remember, both of these companies are in the business of picking olives. Big company, they use automation, they have a higher fixed cost. Lean company, they rely on labor and they have a lower fixed cost. And basically at this point, both companies have sales of 100,000 and their net operating income is 10,000. Given that company B has a higher fixed cost, company B which is big and the Lean company has a higher variable cost. Now let's compute the degree of operating leverage for each company and see how would that affect their bottom line. Well, we compute the degree of operating leverage by taking contribution margin, which is sales minus variable expenses divided by net operating income. And if we do so for Lean company, we find out that the degree of operating leverage equal to four. If we do the same computation for big company, we find out the degree of operating leverage is seven. Obviously, Big has a higher degree of operating leverage. It means the net operating income increases four times as fast as sales for Lean, as fast as sales for Lean company, and it increases seven times as fast as sales for Big company. So if sales increase by 10%, which is something that we looked at when we did the cost structure, what would happen to the bottom line for each company? Notice Big company profit will become 17,000. So simply put, we increased sales by 10%. And notice increasing sales by 10% increased our profit by 70%. That's a huge increase in profit. At the same time, if you look at the Lean company, they also increased sales by 10%. They went from 100 to 110. However, their profit only went up 40%. 40% still good, but 70% is way better. So the higher the degree of operating leverage, the more sensitive the changes in sales to your net income, to your profit. Now bear in mind, also on the downturn, that's also true. So you have to be very careful. Now the degree of operating leverage is not constant. What does that mean? It means you don't get the same degree of operating leverage as the company grows. Let's take a look at this example. In here, we are looking at a company with a 40% contribution margin percentage. They have sales of 75 variable expenses of 45, will give us a contribution margin of 30,000, or fixed cost is 30, 30 divided by 75 equal to 40%, 30 minus 30 equal to zero. We cannot compute the degree of operating leverage. Let's assume sales went up by 5,000. Well, variable expense will go up proportionally. Now the contribution margin is 32, the net operating profit is 2,000. Now if we compute 32 divided by 2, the degree of operating leverage is 16. Let's increase sales from 80 to 100,000. Again, increase variable expenses proportionally. Contribution margin percentage is 40%. Fixed cost is the same, 30,000. Now, and the profit is 10. If we take contribution margin divided by net operating income will give us a DOL of 4. If we increase sales from 100 to 150, the degree of operating leverage is 2. If we increase sales from 150 to do 25, the degree of operating leverage is 1.25. So notice as we are going away from the break-even point will have lower and lower degree of operating leverage. And that's the importance of the break-even. And that's why a lot of managers, they want to get to the break-even because once they go a little bit above the break-even, that small increase in the break-even will yield a larger net operating income. If you have any questions, what you should do now, go to farhatlectures.com and work MCQs. If you're not a subscriber, go ahead and subscribe. I can help you with your accounting course, a CPA preparation. Invest in yourself. Don't shortchange yourself. Accounting is worth it. Good luck, study hard, and of course, stay safe.