4.15 Example:  Interpreting Degree of Operating Leverage

Suppose Wal-Mart’s TTM Sales are expected to increase by 5% and fixed costs remain unchanged.   By how much do Operating Earnings change by?

You can verify that Operating Income has increased by 14.935% = Sales Growth *DOL = 5*2.987. 

Now consider what actually happened from 2008 to 2009.  Actual sales revenue increased by only 0.95% for Wal-Mart and 0.63% for Target.  As a result, the predicted increase in operating income is 3.21% growth for Wal-Mart and 2.37% for Target.  The actual versus predicted is provided below:

Both companies outperformed this prediction.  It is instructive to understand how.

It should be noted, however, that this assumes that fixed and variable costs remain unchanged under the increased sales growth.  For example, both Target and Wal-Mart attained better COGS in 2009 compared to 2008.  That is, after the economic crisis it appears that procurement for both companies were able to negotiate more aggressive terms.

To get to the bottom line, however, requires one additional step which is to understand the impact of financial leverage.