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 complement of 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