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.
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.
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.