Operational gearing describes the relationship between a firm’s fixed and variable costs. Higher fixed costs mean greater operational gearing and vice versa. High gearing makes a firm’s profits sensitive to a change in sales.
For example, if it makes sales of £1,000 with high fixed costs of £800 and variable costs of 10% of sales (£100), profit is £100 (£1,000-£800-£100). If sales rise by 10% to £1,100, profit rises to £190 (£1,100-£800-£110).That’s a 90% increase for a 10% rise in sales. However, the effect slams into reverse should sales drop.
That’s why firms with high operational gearing, such as banks (where the fixed costs are mainly people and property), have to take drastic cost-cutting action once sales start falling.
• See Tim Bennett’s video tutorial on operational gearing: Why costs matter