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.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
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
-
Pension warning: one in five don’t know how much is going into their pensionHow to check your pension contributions and why it matters
-
50,000 power of attorney applications rejected – how to avoid common mistakesA freedom of information request shows that thousands of lasting power of attorney (LPA) applications are rejected due to errors. We explain how to avoid mistakes and reveal tips to make the process as straightforward as possible
