Definition
Operational Gearing can define the relationship between the company’s fixed costs and the variable costs. In this case, fixed costs can be defined as the company’s costs regardless of the output that they are operating at.
On the other hand, as far as variable costing is concerned, these are the costs that fluctuate with the overall level of turnover involved.
The firm’s fixed costs can be directly proportionate compared to the degree of operational gearing that the firm has.
Therefore, this means that the higher the fixed costs (in proportion to total costs), the higher the operational gearing.
List the operating gearing ratios by industry
Analysis
If the business has no operational gearing, it can be seen that profits are likely to increase at a rate similar to the increase in sales. Higher operational gearing also makes the firm’s profit volatile as compared to changes in sales.
The biggest drawback, in this case, is the fact that it then becomes increasingly difficult to forecast earnings for the company, essentially because it becomes increasingly harder to forecast earnings.
Also, it must be considered that a small change in assumptions can have a relatively bigger impact in terms of eventual outcomes generated in this case.
Therefore, the company’s operational gearing is essential because it gives a deeper insight into the overall risk profile of the investment.
Furthermore, it also helps in clearing opportunities or threats caused by subsequent changes in structure within the company and the overall changes in strategy.
To calculate the operational gearing ratio, several ways can be used. Firstly, it can be calculated by dividing the contribution of the company by the operating profit.
Alternatively, a backward method can be adopted where fixed costs are added back to the operating profit, and then the resulting amount is divided by the operating profit. Both these methods can be used, and both of them derive similar results.
Examples of operating gearing
Operating Gearing Ratio tends to wary from industry to industry. This is essential because of the reason that some industries have higher fixed costs as compared to others.
For example, airlines and hotels tend to have higher operational gearing. This is because of the high fixed costs required to run and sustain the company with higher operational gearing.
Similarly, as far as a steel mining company is concerned, they too have higher fixed costs because of using machines and employee-related expenses.
Hence, it can be generalized that most industries that rely on large-scale manufacturing and are product-centric have higher operational gearing than other products.
On the other hand, it can be seen that companies that operate in the tertiary sector have relatively lesser operating gearing since their cost structure is largely variable.
Uses of operating gearing
Operating Gearing can be defined as an increasingly important concept because this particular ratio can be used to analyze the company’s performance on several grounds.
For example, this ratio can measure the impact of changes in sales, which ultimately leads to a change in the company’s profitability.
Additionally, it helps to provide a snapshot between fixed costs and variable cost structure within the company.
Using this particular ratio, companies can also identify the relationship between sales and revenue of the company during a particular period.
In the same manner, it can also be seen that operating gearing also provides information about the overall position of fixed operating costs.
Operational Gearing Ratios by Industry Review:
The operational gearing ratio is a financial metric that measures the extent to which a company’s costs are fixed versus variable.
It provides valuable insights into different industries’ cost structures and risk profiles.
Here is a review of the operational gearing ratios by industry based on the provided information:
- Aerospace & Defense (2.5-3.5): The aerospace & defense industry exhibits a relatively high level of operational gearing, indicating a significant proportion of fixed costs. This suggests that the industry’s profitability is closely tied to achieving high production volumes and efficient cost management.
- Automotive (2-3): The automotive industry also demonstrates a moderate to high level of operational gearing. This implies that a substantial portion of its costs is fixed, such as manufacturing facilities and equipment. Fluctuations in sales volume can substantially impact the industry’s profitability.
- Capital Goods (2-3): Capital goods companies, which produce machinery, equipment, and other durable goods, tend to have a similar level of operational gearing as the automotive industry. This indicates a significant reliance on fixed costs, with sales volumes crucial in their financial performance.
- Chemicals (1.5-2.5): The chemicals industry shows an average operational gearing ratio. This suggests a balanced mix of fixed and variable costs. While the industry still has a significant proportion of fixed costs, it may have more flexibility to adjust expenses based on market conditions.
- Consumer Cyclical (1.5-2.5): Consumer cyclical companies, which produce goods and services highly influenced by economic cycles, exhibit an average operational gearing ratio. This indicates a mix of fixed and variable costs. Companies in this industry must carefully manage costs to adapt to changing consumer demand.
- Consumer Defensive (1-1.5): The consumer defensive sector, comprising companies that produce essential goods like food, beverages, and household items, shows a relatively low operational gearing ratio. This suggests a higher proportion of variable costs, enabling companies to adjust more quickly to changes in demand.
- Energy (2-3): The energy industry, including oil, gas, and renewable companies, demonstrates moderate to high operational gearing. This reflects the substantial fixed costs of exploration, production, and infrastructure development.
- Healthcare (1-1.5): The healthcare industry exhibits a relatively low operational gearing ratio, indicating a higher proportion of variable costs. This suggests that expenses can be more readily adjusted based on patient demand and changing healthcare regulations.
- Industrials (1.5-2.5): The industrials sector, comprising a wide range of manufacturing and service companies, shows an average operational gearing ratio. This implies a mix of fixed and variable costs, with production volumes playing a significant role in the financial performance of these companies.
- Information Technology (1-1.5): The information technology industry demonstrates a relatively low operational gearing ratio, suggesting a higher proportion of variable costs. This can be attributed to the industry’s dynamic nature, focusing on software development, cloud services, and technology solutions.
- Materials (1.5-2.5): The materials industry, encompassing companies involved in mining, metals, and construction materials, exhibits an average operational gearing ratio. This implies a balanced mix of fixed and variable costs, with production volumes and commodity prices influencing profitability.
- Telecommunications (1-1.5): The telecommunications industry shows a relatively low operational gearing ratio, indicating a higher proportion of variable costs. Companies in this sector can adjust their expenses based on customer demand and changing market dynamics.
- Utilities (1-1.5): The utility sector, including electric, gas, and water companies, demonstrates a relatively low operational gearing ratio. This suggests a higher proportion of variable costs, allowing companies to adapt their expenses to changes in energy demand and regulatory requirements.
It’s important to note that the operational gearing ratios provided are ranges and can vary within each industry.
Additionally, company circumstances and strategies can influence their specific operational gearing ratio.
Limitation of Operational Gearing:
- Does not consider variable costs: One significant limitation of operational gearing is that it solely focuses on fixed costs and neglects variable costs. As a result, it may provide a misleading impression of a company’s true profitability, especially if variable costs play a substantial role in the overall cost structure. Relying solely on operating gearing without considering variable costs can lead to inaccurate financial assessments.
- Not a good predictor of future performance: Operational gearing is calculated based on historical data, which makes it an unreliable predictor of a company’s future performance. Since a company’s fixed costs, revenue, and variable costs can change over time, the operational gearing ratio may not accurately reflect the company’s future financial health.
- Not a good measure of risk: While operating gearing is sometimes used to indicate risk, it has limitations. It fails to consider other factors that can influence a company’s risk, such as its level of financial leverage, liquidity position, and competitive landscape. Relying solely on operational gearing to assess risk may lead to incomplete risk analysis.
- Can be manipulated: Companies can manipulate their operational gearing ratio through strategic decisions. For instance, management could intentionally increase fixed costs to artificially inflate the operational gearing ratio, making the company appear more stable and profitable. This manipulation could mislead investors and stakeholders and obscure the company’s financial position.
While operational gearing provides insights into a company’s cost structure, it is essential to consider its limitations and use it with other financial metrics to understand its financial performance, risk profile, and potential prospects.
Advantages of Operational Gearing:
- Increased operating profits with small increases in sales: Companies with high operational gearing can benefit from significant increases in operating profits even with small increments in sales. This is due to the leverage effect, where a slight rise in sales leads to a substantial increase in contribution margin. As fixed costs remain relatively constant, the incremental revenue generated from additional sales flows directly to the bottom line, resulting in higher operating profits.
- Increased financial leverage: High operational gearing often goes hand in hand with increased financial leverage. Companies can utilize a relatively small amount of equity to generate a larger debt. By taking advantage of financial leverage, companies can magnify their returns on equity. However, it is essential to note that higher financial leverage increases the company’s risk exposure.
- Increased bargaining power with suppliers: Companies with high operational gearing possess increased bargaining power. This advantage arises from their ability to withstand changes in input prices more effectively. Since a larger portion of their costs consists of fixed expenses, they are less susceptible to fluctuations in raw materials prices or other inputs. This allows them to negotiate more favorable terms with suppliers and potentially secure lower costs, enhancing their profitability.
- Increased ability to weather economic downturns: High operational gearing gives companies a greater ability to withstand economic downturns. This resilience stems from the fact that their profitability is less dependent on changes in demand. Even in challenging economic conditions where overall demand may decline, companies with high operational gearing can maintain more stable profits due to their lower variable cost structure. This stability helps them navigate through downturns and positions them for faster recovery when economic conditions improve.
It’s worth noting that while high operational gearing offers these advantages, it also comes with potential risks.
Companies with high fixed costs are more vulnerable to negative shifts in sales volumes, as a decline in revenue can lead to amplified losses.
Therefore, it’s crucial for businesses to carefully manage their operational gearing and assess the associated risks to ensure sustainable profitability and financial stability.
Conclusion
Therefore, it can be seen that operating gearing shows the overall extent of financial costs as a component of other cost components within the company’s operational tools.
It can be used alongside numerous other ratios to get a deeper insight into its performance and the possible areas of improvement within the company.
In this regard, it is also increasingly important to realize the fact that operating gearing does not really justify if a company is ‘good’ or ‘bad’ in the literal sense. Similarly, it does not guarantee profit margins too.
This is because of the reason that it highly varies from industry to industry, and these individual differences do not directly impact profitability.
However, it is always beneficial for companies to have their fixed costs under control so that they are able to sustain themselves under unprecedented circumstances.
