The flow from the pump enters the inlet port and passes across the needle valve, then on through the sleeve, past the compensating spool and out through the regulated port. The passage of oil across the needle valve creates a pressure difference which is sensed across the compensating spool. When the flow is sufficient to create a 7 bar pressure difference across the needle valve the compensating spool will begin to move uncovering the radial holes in the sleeve and opening up a path to the bypass port. Oil will therefore begin to pass to the bypass line. If the flow tries to increase across the needle valve, and so to the regulated port, there will be an increase in pressure difference sensed by the compensating spool causing it to move further against the spring, open further the line to the bypass port and limiting the flow to the regulated line. If the inlet flow falls below the setting of the valve the pressure difference across the needle valve will drop below the 7 bar needed to keep the bypass line open therefore the priority line is always satisfied before the bypass line opens. Changes in operating pressure on either of the two outlets will alter the inlet pressure to the higher of the two pressures (plus the control pressure which is 7 bar). If the working pressure in the regulated line is higher than that in the bypass line then the tendency would be for the flow to try to take the easy way out and flow down the bypass line. This would detract from the flow passing across the needle valve lowering the pressure difference causing the compensating spool to shift, increasing the restriction to the flow to the by-pass and reducing the restriction of the flow to the regulated line. In this way the compensating spool will maintain the regulated or priority flow at a constant level.
If the working pressure in the bypass line is higher than that in the regulated line then there would be a tendency for the flow to increase through the regulated line, increasing the flow would increase the pressure difference across the needle valve and cause the compensating spool to meter the regulated line.