Operational gearing

Operational gearing describes the relationship between a firm's fixed and variable costs.

Updated 18 July 2018

Operational gearing (also known as operating leverage) describes the relationship between a company's fixed costs (costs that it has to pay, regardless of how many sales it makes) and variable costs (those that rise and fall along with the level of turnover). The higher a firm's fixed costs are as a proportion of total costs, the higher its operational gearing.

Airlines and hotels have high operational gearing, for example, because of their high fixed costs (mainly property and staff) an aeroplane still requires a full complementof staff to get from A to B, regardless of how many seats are filled.

High operational gearing makes a firm's profits more sensitive to a change in sales, which in turn, makes it more difficult to forecast its earnings (as a small change in assumptions can have a big impact). Here's an example of how operational gearing can affect a company's earnings. Say a firm makes sales of £1,000 in a given period. It has fixed costs of £800, and variable costs of 10% of its sales (so if sales are £1,000, its variable costs amount to £100). So the profit is £100 (£1,000-£800-£100).

If sales then rise in the next period by 10% to £1,100, the profit rises to £190 (£1,100-£800-£110). That's a 90% jump for a 10% rise in sales, which explains why companies with high operational gearing can be very attractive if you can invest in them at the right time in the cycle.

However, this effect slams into reverse should sales drop. Let's say that sales had fallen by 10%, rather than risen, in the subsequent period. On sales of £900, the company would still have £800 in fixed costs to pay, and then a further £90 in variable costs, leaving a profit of just £10.

Understanding a company's operational gearing will give you a better grasp of how risky it is as an investment, and may also flag up opportunities or threats created by a change of strategy or structure.

See Tim Bennett's video tutorial on operational gearing: Why costs matter

Recommended

Resource curse
Glossary

Resource curse

The term “resource curse” refers to the observation that countries with abundant natural resources also tend to be less economically developed than th…
14 Jan 2021
Balance of payments
Glossary

Balance of payments

The balance of payments refers to the accounts that sum up a country's financial position relative to other countries.
8 Jan 2021
Yield-curve control
Glossary

Yield-curve control

Yield-curve control is when a central bank aims to control long-term interest rates by pledging to buy (or sell) as many long-term bonds as needed to …
25 Dec 2020
Intangible assets
Glossary

Intangible assets

An intangible asset is anything that a company owns that isn’t physical.
25 Sep 2020

Most Popular

Prepare for the end of the epic bubble in US stocks
US stockmarkets

Prepare for the end of the epic bubble in US stocks

US stocks are as expensive as they’ve ever been. How can you prepare your portfolio for a bubble bursting?
18 Jan 2021
Bitcoin: fool’s gold or the new gold?
Bitcoin

Bitcoin: fool’s gold or the new gold?

With bitcoin hitting new highs last week, and close to becoming a mainstream investment, is it really gold for the 21st century?
15 Jan 2021
It's not just the UK – we're seeing pandemic housing booms across the globe
Property

It's not just the UK – we're seeing pandemic housing booms across the globe

Soaring house prices aren’t just a UK thing, they’re a worldwide phenomenon. And it’s no coincidence – the underlying cause is much the same. John Ste…
18 Jan 2021