The topic of this blog is how operational gearing affects your business. In a nutshell, it shows much risk you have and affects your survival, growth, and prosperity. But let’s take a step-by-step approach and start with operational gearing first.
Operational gearing explained
When we say operational gearing we mean the effect that fixed costs can have on the relationship that exists between sales and your operating profits. If your business has no operational gearing, then profits would rise at the same rate that sales increase.
This blog (and video) will help you understand how this concept works and why it’s important to your business. We’ll also share our FREE online calculator which shows you quickly what your operational gearing looks like. Moreover, it allows you to play with options for managing your company’s operational gears, so they do not get in the way of profit growth.
You can also see operational gearing as an indicator that measures the degree to which an increase (or decrease) in revenue affects your profits.
The type of costs your business has
To understand how operational gearing affects your business, we have to look at the costs that your business has. Naturally, it will have a mix of costs – fixed and variable costs.
- Fixed costs stay the same, they do not change.
- Your variable costs on the other hand do change, they do fluctuate. What makes them change is your business activity, for example when you are selling, or making something.
Examples of how operational gearing affects business
So, let’s look at these costs when it comes to your car. If it stays parked on your driveway, you still must pay insurance and road tax. But, once you stay driving it, your fuel costs start to increase. Insurance and road tax are your fixed costs. Fuel is your variable cost, and it will depend on your activity. This would include the distance you drive, the number of journeys you go on, etc.
To come back to the topic of business – if your business makes things then making the things is one activity. In this case, your warehouse rent and staff are your fixed costs. Once you start selling (another activity), then the costs of packaging and delivery will go up. They will be your variable costs. Should your business be in hospitality then no customers (business activity) mean costs like rent, chefs, and waiters’ salaries (fixed costs) stay the same, and food and drink costs (variable costs) do not move.
How costs affect your business risk and profitability
The amount and type of costs you have affects your business risk and profitability. Adding more fixed costs can increase your risk. This is what operational gearing shows. It’s a measure of that risk.
Gearing, which is also called leverage, measures the level of fixed costs against your total costs. The more fixed costs you have, the greater the risk. And vice versa, the less you have, the smaller the risk.
Nevertheless, high fixed costs are not necessarily a bad thing. In fact, many businesses generate good levels of profits with high fixed costs. Obviously, operational gearing affects your business but depending on what cost structure you have, you’ll need to set specific goals to be able to make good profits.
An example that explains this is the following. Imagine you are deciding whether to employ someone or use a freelancer. Lots of good reasons for either, but cost will be a factor. Employing someone will be an extra fixed cost. Take for example the wages, pensions, and employer’s national insurance. On the other hand, if you use a freelancer, then normally there’s no need to worry about pensions and national insurance. The freelancer cost will be your variable cost. Use our FREE online payroll calculator to calculate your payroll costs.
When your sales increase you will make more profit where you have employed someone, less so when that person is a freelancer. Why should that be so? Well, your fixed costs are spread over more sales, so the average cost per unit, per pound of sales goes down, and profit goes up. Obviously, when sales dip, then the reverse happens, and less profit will be made.
Different cost structures will have different impacts when an increase and decrease in sales happens. So, taking the time to decide what kind of cost structure you want to have for your business will play a role in your numbers. It’s how operational gearing affects your business that you need to fully understand to be able to choose the best solution for you.
The more fixed costs there are in a business, the greater its need for high levels of revenue to break even or make a profit. This means it’s important for companies with high levels of fixed costs to focus on ways they can grow their revenues quickly and efficiently.
We’ve created this free online calculator so you can calculate your own level of operational gearing! It’s easy to use – just input some basic information about your company, and we’ll do all the calculations for you. You don’t need any special knowledge or training to understand what it means for your business.
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