Should a business increase or reduce the number of units it is producing? Should it rely on borrowed money? The answer depends upon how a change would affect risk and return. Operating leverage refers to the impact of a change in the level of output on the operating income. The extent to which a business uses fixed costs (compared to variable costs) in its operations is referred to as "operating leverage." When operating leverage is used extensively, there will either be an increase in profits or losses, depending on the volume of sales.

The degree of operating leverage can be measured with the help of the following equation:
DOL = [c(p -v)] / [q(p - v) -f] divided by c/q
Where:
DOL = degree of operating leverage
p = price per unit
q = original quantity
c = change in quantity
v = variable cost per unit
f = total fixed costs
The above equation simplifies to:
DOL = q(p - v)divided by q(p - v) – f

That is: Degree of operating leverage = Sales revenue less total variable cost divided by sales revenue less total cost
With a lower level of operating leverage, the business shows poor growth in profits as sales rise, but faces less risk of loss as sales decline.
A Suggested New Way to Measure Operating Leverage
m = pq - (qv + f) divided by pq
Where: m = profit margin before interest and taxes, that is, EBIT/sales revenue
The greater the value of this ratio, the lower the ratio of the variable cost per unit to price per unit; so, the greater the ratio, the higher the operating leverage.

Application of operating leverage
1. DOL measures the percentage change in EBIT, which results from a change of one percent in the level of output.
2. DOL helps in measuring the business risk.

Financial leverage is the name given to the impact on returns of a change in the extent to which the firm’s assets are financed with borrowed money.
The degree of financial leverage (DFL) is defined as the percentage change in earnings per share [EPS] that results from a given percentage change in earnings before interest and taxes (EBIT), and is calculated as follows
DFL = Percentage change in EPS divided by Percentage change in EBIT
This calculation produces an index number which if, for example, is 1.43, means that a 100 percent increase in EBIT would result in a 143 percent increase in earnings per share

DFL = [q(p - v) - f ]divided by [q(p -v) – f-i]-d / [1-T]
Where:
DFL=degree of financial leverage.
p = price per unit
q = original quantity
v = variable cost per unit
f = total fixed costs
i=interest.
d=dividend paid.
T=tax payable.

Application of financial leverage
1. DFL measures the percentage of change in earnings per share that results from a change in one percent change in EBIT.
2. It helps in measuring the financial risk of the company.

Measuring Combined Leverage
Combined leverage is the product of operating leverage and financial leverage.
That is: DTL=DOL*DFL
Where: DTL=degree of total leverage.
DOL=degree of operating leverage.
DFL=degree of financial leverage.

Application of total leverage
1. Degree of total leverage measures the percentage change in EPS that results from a change in one percent in output.
2. It assists in measuring the firm’s total risk.