UK 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 (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 also referred to as operational leverage.
By measuring the operational gearing of a company you can determine how good that company is at generating profit from their fixed costs.
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 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.
Operational Gearing is the term that is used to describe the effect that fixed costs in a business can have upon the relationship that exists between a companies sales and the business’s profits.
3 easy steps to calculate a company’s operational gearing.
Step 1 – You must calculate the contribution margin. The contribution margin is found by taking the variable expenses away from the total sales. Variable expenses are the costs that actually increase with each new sale. Cost of materials, shipping and commission are all examples of variable expenses, however, there are many others. These variable expenses need to be subtracted from the total sales and then you will find the contribution margin.
A company has made total sales of £200,000 in one period. The variable expenses were the cost of the goods that were sold in that period, which was £60,000, commissions paid to your sales team, which stood at £40,000, and shipping costs of £20,000.
So the contribution will be £200,000 (in sales) – £60,000 (cost of goods) – £40,000 (commission) – £20,000 (shipping costs) = £80,000.
The contribution margin is £80,000.
Step 2 – Determine the operating income.
The operating income is determined by taking the operating expenses (with the exception of taxes and interest) away from the total sales.
You should have already deducted your variable expenses away from the total sales, it is now time to subtract the fixed costs and we will have determined the operational income.
Fixed expenses can include rent, insurance, wages, utilities and advertising.
Let us suppose for our imaginary company that the fixed expenses are as follows. Wages £36,000, utilities £4,000, insurance £10,000, rent £6,000 and advertising of £4,000. So our fixed expenses are £60,000.
The operating income is total sales without fixed and variable expenses.
Our company’s sales ledger stood at £200,000, its variable expenses were £120,000 and its fixed costs were £60,000.
The operating income is £200,000 – £120,000 – £60,000 = £20,000.
Step 3 – determine the operational gearing
Now we must divide the contribution margin by our operating income. Our companies contribution margin was £80,000, and its operating income was £20,000.
So, 80,000 divided by 20,000 is 4.
The operational gearing of our company is 4.
The operational gearing formula is determined by the multiplication of the quantity by the difference between the variable cost and price of each unit and then dividing it by the outcome of the multiplication of quantity and the difference between variable cost and price per unit subtracting any fixed costs.
The formula is as follows:
Degree of operational gearing or leverage =
Quantity x (price – variable cost per unit)
Quantity x (price – variable cost per unit) – fixed operating costs
A more general way to express this equation is as follows:
Degree of operational Gearing =
Sales – Variable costs
Bill runs a successful software company. Most of the fixed costs incurred by Bill’s software company are the upfront costs for developers and marketing. The upfront costs for Ill software company are £780,000 which pays the salaries of the developers. The cost per unit is £0.08. Bills software sells a £25 per unit. Bill’s company makes sales totalling 300,000 units.
Based on the company’s fixed costs, variable cost per unit and sales, its operational gearing is determined like this:
112% = 300,000 x (25 – 0.08)
(300,000 x (25 – 0.08) – 780,000
Degree of Operational Gearing = [Quantity x (Price – Variable Cost per Unit)] / Quantity x (Price – Variable Cost per Unit) – Fixed Operating Costs = [300,000 x (25-0.08)] / (300,000 x (25-0.08) – 780,000 = 7,437,000 / 6,657,000 = 112% or 1.12.
This means that if Bill’s company has a 10% increase in sales then he can enjoy a 12% increase in profits due to the fact that 10% x 11.2 = 120%.
The operation leverage or operational gearing phenomenon is where even the smallest change in the sales that a company makes can have a large impact on the operating income. The operating leverage phenomenon is caused due to the existence of fixed operating costs.
A business that has both high financial leverage and high operational gearing is sometimes considered to be a risky financial venture. The implication of high operating leverage is that a company has high margins yet is making few sales. This could pose large risks if a business incorrectly or falsely forecasts any future sales. If a business makes a sales forecast that is even slightly higher than the actual this could lead to a massive difference in budgeted and actual cash flow, which could impact in the future the company’s operating ability.
The largest risk that can occur from high financial leverage is when a business’s return on ROA is not greater than the excess on the loan, which lowers a company’s profitability and returns on equity.
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This glossary post was last updated: 23rd December 2018.