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.

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

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).

Advertisement
Advertisement - Article continues below

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

Advertisement

Most Popular

Visit/investments/stocks-and-shares/600863/sirius-minerals-anglo-american-takeover
Stocks and shares

Do you own shares in Sirius Minerals? Here’s what you need to do now

Mining giant Anglo American has proposed a cash takeover of Yorkshire-based minnow Sirius Minerals. Unhappy shareholders must decide whether to accept…
20 Feb 2020
Visit/investments/commodities/gold/600874/gold-is-at-its-highest-level-in-years-heres-how-to-invest
Gold

Gold is at its highest level in years – here’s how to invest

Gold's rise at a time when the dollar is unnervingly strong isn't unheard of – but it is curious. John Stepek explains what's going on, and what it me…
21 Feb 2020
Visit/economy/uk-economy/600862/britains-economy-might-spring-a-surprise-on-the-doomsayers-this-year
UK Economy

Britain’s economy might spring a surprise on the doomsayers this year

The UK economy is looking pretty good – we’re more at risk of a boom than a bust, says John Stepek. Here’s why, and what it means for your portfolio.
20 Feb 2020
Visit/investments/commodities/600729/the-rare-earth-metal-that-wont-be-a-secret-for-long
Sponsored

The rare earth metal that won't be a secret for long

SPONSORED CONTENT – You can’t keep a good thing hidden forever; now is the time to consider Pensana Rare Earths and the rare earth metals NdPr.
31 Jan 2020