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.
- 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