Business, Legal & Accounting Glossary
The ratio of fixed operating costs to variable operating costs.
Operational gearing is the effect of fixed costs on the relationship between sales and operating profits.
Operational gearing is the effect of fixed costs on the relationship between sales and operating profits. If a company has no operational gearing, then operating profit would rise at the same rate as sales growth (assuming nothing else changed).
Operational Gearing (also known as operating leverage) is the name given to describe the effect that fixed costs can have on the relationship that exists between sales and businesses operating profits. If a business has zero operational gearings, then profits would rise at the same rate that sales increase. This assumes that no other factors have changed. Operational gearing is simple and important – and often neglected.
Operational gearing is also referred to as operational leverage.
The higher a firm’s fixed costs are as a proportion of total costs, the higher it’s operational gearing.
By measuring the operational gearing of a company you can determine how good that company is at generating profit from their fixed costs1.
Fixed costs are the costs that a business has to pay, irrespective of the number of sales that a company makes. Some examples of fixed costs include yet are not exclusive to rent, salaries, insurance and interest expenses on loans.
Variable costs are costs that a borne by a business that will change. Some examples of variable costs are but not exclusive to are materials, production costs and commission fees.
Hotels and airlines are known to have high operational gearing because of their high fixed costs. These fixed costs are mainly expenditure on staff and property. For example, a plane will still need all of its staff to fly from London to Dubai, regardless if all of the seats on the plane have been filled.
If a company has high operational gearing, it becomes more sensitive to any changes in regards to sales that it makes. This also makes it difficult for anyone to make a forecast of the companies earnings, as any small change in sales can have a large impact.
Let us imagine a company that makes £2,000 in sales in any given time period. The companies fixed costs are £1,600, and the companies variable costs are 10% of the business’s sales, so for this example, the variable costs will be £200 (because 10% of £2,000 is £200). So if the company has made sales of £2,000 and has fixed costs of £1,600 and variable costs of £200 it has made a profit of £200. £2000 – fixed costs of £1,600 – variable costs of £200 = £200 profit.
Let us further imagine that the sales of the company for the next period rise by 10%. So now our company has made sales of £2,200. It still has fixed costs of £1,600, the variable costs are still 10% so the variable costs are now £220. So to find the profit you have sales of £2,200 – fixed costs of £1,600 – variable costs of £220 = £380 profit. That is an extra £180 in profit, which is a 90% rise in profit for just a 10% rise in sales. This explains why businesses with high operational gearing can appear to be very attractive for investment, as long as you invest at the right time.
However, if there is a decrease in sales then you still have your fixed costs to pay. The effect that has been described above completely reverses. If sales had in fact dipped by 10% and not increased the picture would have looked very different. If the company had made sales of £1,800, it would still have to pay fixed costs of £1,600 and the variable costs of £180. So, £1,800 – £1,600 – £180 = £20 profit.
By understanding businesses operational gearing you will have a better idea of whether or not any intended investment is risky. This may also lead to understanding better when opportunities for investment are at their best or when any changes in the structure or strategy of a business may threaten your investment.
Investors became increasingly concerned as the operational gearing of the company steadily increased.
Operating gearing measures the percentage increase in profits resulting from a given percentage increase in sales.
Operating gearing is an important factor affecting business risk.
The earnings generated at home are suffering as operating gearing diminishes and companies can’t fully pass rising production costs onto customers.
Smaller, unlisted firms have likely experienced a similar trend, aggravated by lower margins given their higher operational gearing.
Given our large volume of operating leverage we ought to stay patient and wait until the time is right before proceeding.
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This glossary post was last updated: 9th December, 2019 | 4,941 Views.