Operational gearing is linked to asset leverage. Operational gearing measures the relationship between fixed and variable costs. It is high if the proportion of fixed costs exceeds that of variable costs in the total cost amount. The implications of the operational gearing decision are that if it is high then profit margins are also high, but an organization becomes vulnerable to demand/volume fluctuations because in order to achieve the full benefits of high operational gearing it must achieve high production volumes. Clearly this is reserved with a low value.
If components are purchased rather than manufactured the fixed content of total costs is lowered and while the suppliers earn margin from the transactions with the assembler organization, they also share the risk if a market downturn occurs.
Significance of operational gearing
Operational gearing indicates the degree to which an organisation's profits are made up of variable (as opposed to fixed)cost. The significance of operational gearing is as follows:
- If contribution is high but PBIT is low, the company has a high proportion of fixed costs, which are only just covered by contribution. Business risk, as measured by operational gearing, will be high
- If contribution is not much bigger than PBIT, the company has a low proportion of fixed costs, which are fairly easily covered by contribution. Business risk, as measured by operational gearing will be low.
Operational gearing, like financial gearing, affects the volatility of earnings. If a company has high operational gearing, a small percentage change in sales revenue will have a much greater percentage change in operating profits. The proportional size of the change is higher than for a company with low operational gearing.
Operational and capital gearing in perspective
There are certain simplifications built into this analysis which should lead to a cautious use of the model relating to operating and capital gearing. For example, very few concerns have one single product or service, their fixed/ variable cost structure reflecting an amalgam of the sales mix of a range of products or services.
This process links the financing decision and the investment decision areas very strongly. There will however, need to be some level of 'trade-off' between operating and capital gearing in order to achieve the optimum conversion of sales. As a manager contemplating the introduction of say, new advanced technology equipment, you can appreciate that the introduction of such equipment may alter the company's fixed/ variable cost structure- its operational gearing-and, further, if this investment is not appropriately financed, then the optimum conversion of sales can be missed. Even less desirable is the possible mismatch of the two sections of gearing so that a neutralizing effect results. Operational managers must be aware that their involvement in investment decision making has implication for the financing decision simultaneously.
Sky-high operating gearing
British Sky Broadcasting Group, the satellite television broadcast, is an obvious example of a business with high operating gearing. Nearly all of its costs are fixed in that they not vary with the number of subscribers that it has or the value of its advertising revenues. This means that any increase in total revenues is likely to have a strong favourable effect on profit. The business acknowledged this in its 2005 annual report where it said ' These figures highlight the operational gearing of our business and the profitability of adding new subscribers' before going on to explain how an 11 per cent increase in revenue led to an increase of 34 per cent in operating profit.
Examples of Operational gearing
- A retail store is an example of a business that has high operational gearing. Their fixed costs include rent, insurance, utilities, and property taxes. These costs are constant regardless of the number of customers that the store has. This means that if a store has a large number of customers, the variable costs, such as labor, inventory, and supplies, become relatively small in comparison and the store can make a larger profit margin.
- A restaurant is another example of a business that has high operational gearing. Restaurants have fixed costs such as rent, insurance, utilities, and property taxes. They also have variable costs that include food, labor, and supplies. If the restaurant is able to attract a large number of customers, the variable costs become relatively small in comparison and the restaurant can make a larger profit margin.
- A manufacturing business is another example of a business that has high operational gearing. Manufacturing businesses have fixed costs such as rent, insurance, utilities, and property taxes. They also have variable costs that include raw materials, labor, and supplies. If the business is able to produce and sell a large number of products, the variable costs become relatively small in comparison and the business can make a larger profit margin.
Advantages of Operational gearing
- Operational gearing allows the company to reduce costs through economies of scale. This includes reducing the cost of raw materials, labor, and other production costs.
- Operational gearing increases efficiency and productivity, as fixed costs are shared among multiple units of production. This enables the company to increase production at a lower cost.
- Operational gearing provides the company with greater financial flexibility and freedom. The company is able to adjust to changes in the market quickly, as it does not have to worry about high fixed costs.
- Operational gearing reduces the risk of incurring significant losses, as the company is able to adjust to changes in demand and production levels quickly.
- Operational gearing also allows the company to increase its profitability. Since fixed costs are shared among multiple units of production, the company can increase its profits without increasing its costs.
Limitations of Operational gearing
- Operational gearing is limited in its ability to accurately reflect the underlying operational structure of a business. It takes into account only the fixed and variable costs, but does not consider other components such as capital costs, depreciation, debt service costs, and other non-operational costs.
- Operational gearing also fails to consider the impact of an organization’s ability to take advantage of economies of scale. For example, a business may be able to reduce fixed costs if it can increase production to a certain level, but this would not be reflected in the operational gearing ratio.
- Additionally, operational gearing is a static measure that does not take into account changes in the business environment or operational structure. This means that operational gearing can become outdated as the business grows or the environment changes.
- Operational gearing also does not take into account the impact of certain operational activities, such as marketing and customer service, that are not necessarily captured in the fixed and variable cost components.
- Business Process Improvement: This involves streamlining the existing processes to reduce costs, improve efficiency and quality.
- Outsourcing: One way to reduce fixed costs is to outsource or subcontract certain activities or processes to external entities. This would allow the organization to focus on core activities and reduce costs associated with non-core activities.
- Automation: Automation can be used to reduce labor costs, improve accuracy, and reduce the time taken to complete a particular task.
- Employee Motivation: Motivating employees to work harder and better can help improve operational efficiency and productivity.
- Just-in-Time (JIT) Inventory Management: This involves reducing the amount of inventory in the warehouse by only ordering and having on-hand the exact amount of inventory needed to meet customer demand.
In summary, operational gearing is a technique used to measure the relationship between fixed and variable costs, and it can be improved by business process improvement, outsourcing, automation, employee motivation and just-in-time inventory management. By implementing these approaches, organizations can reduce fixed costs, improve efficiency and quality, and reduce labor costs.
- D. Walters, M. Halliday 2017, p.56
- Financial Management 2015, p.274
- A. Parkinson 2012, p.81
- E.J. McLaney, P. Atrill 2007, p.312
- Financial Management, (2015), BPP Learning Media, London.
- McLaney E.J., Atrill P. (2007), Accounting: An Introduction, Pearson Education, Edinburgh.
- Parkinson A. (2012), Managerial Finance, Routledge, New York.
- Walters D., Halliday M. (2017), Marketing and Financial Management: New Economy, Macmillan, London.
Author: Dawid Barcik