Understanding operational gearing: Operational gearing is a term used to explain an important relationship between the two different types of costs of a business – fixed and variable costs. And because any business needs to have a good grasp of their finances (the money coming in and the money going out) you’re probably guessing by now that you definitely need to know about operational gearing and how it affects your business.
So, operational gearing (or also operating leverage) is about the way that a business spends its money. It’s the proportion of fixed costs and variable costs.
Companies that have higher fixed than variable costs are highly operationally geared companies. The bigger the discrepancy, the more highly geared the company is. On the other hand, if a company’s costs are predominantly variable, we say that it’s low operationally geared.
Why is it necessary to know which type of costs are dominant for your company, you might wonder? Here are two main reasons:
1. Business risk
Risk is a big and scary word. But the reality is that every company faces it, and it’s better to be prepared than caught off-guard. It’s an important aspect for business owners to consider as they want to ensure smooth sailing. It’s also a red flag (or not) to potential investors. Let’s see how operational gearing puts risk into perspective.
If you’re highly operationally geared i.e. your fixed costs are larger than your variable costs, then when you have low sales:
- Your fixed costs stay the same no matter how much you sell, so you’ll still have to cover them (ouch!).
- Your variable costs decrease too. But as they make for only a small portion of your total costs, you won’t see a dramatic cost reduction.
So, when there’s a decrease in sales, profits drop faster. That’s why businesses with high operational gearing are riskier.
For companies with low operating leverage, it would be quite the opposite. As their variable costs are dominant, whenever they face low sales, their costs will significantly decrease – thus, making them not as risky.
2. Making profit
Companies with high operational gearing
On the bright side, when your sales increase, the following will happen:
- Your fixed costs stay the same no matter how much you sell, so you won’t see any changes there.
- Your variable costs will increase. But since they are the lesser part of your costs, you won’t see a dramatic increase in costs.
So, although you’re considered to be a business with greater risk, when it comes to profit, you’re able to make more than a company with low operational gearing.
Companies with low operational gearing
If you have low operating gearing (leverage), you need to know that making more profit will involve having a significant increase in sales.
Why is this?
When your variable costs are higher, it means that your profit margins are smaller. For example, you have a contractor to make a specific product or provide a specific service. From each unit price (product or service price), you need to subtract the cost for the contractor. And the more units you sell, the greater the costs (you’ll need to pay the contractors more). Which actually means that if your sales increase by 30%, you’d actually make much less profit than a company that’s highly geared (that’s had the same increase in sales).
Hopefully, you can see why Understanding operational gearing shows the kind of impact your operating gearing has on your business. As both types of operational gearing have their pros and cons, it is up to you how you want to structure/adapt your business costs so that you achieve your goals faster.
If you’d like to check your operational gearing, we’ve created this free online calculator. It’s easy to use – just input some basic information about your company, and we’ll do all the calculations for you.
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