Degree of Operating Leverage (DOL), Operating Profit Margin and Growth
Keywords:
DOL, degree of operating leverage, profit margin, growth, fixed cost, variable cost, contribution marginAbstract
This paper has three objectives. Firstly, we explore relationships between growth rates of sales, cost, and profit and their associated margins. We provide formulae that relate all these variables and derive the implications. Secondly, we show further that if we assume a constant fixed cost and a constant variable cost ratio, then we can deduce contribution margin ratio (cm), variable cost as a proportion of sales (vc) and fixed cost as a proportion of sales (fc) from operating margin ratio (om) and degree of operating leverage (DOL). In addition, we can also infer sales breakeven simply from sales and profit growth rates.
Thirdly, we relax the above assumptions by assuming a known change in fixed cost and variable cost ratio. These changes could be approximated from financial statements and industry price index series. Our approach could still estimate cm, vc, fc and om. In addition, we also extend Arellano (2007)’s method to show a relationship between a change in margin and fixed cost in this case.
We also provide implications in terms of financial statement analysis. One of the key implications is that if sales growth is higher than cost growth, then a firm with a higher operating profit margin ratio will have a lower profit growth compared to that of another firm with a lower margin. The result is reversed when sales growth is lower than cost growth.
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