What is Operational Gearing?
Operational Gearing is the company’s behavior between spending on fixed cost and variable cost in order to generate a sale, it is also known as operating leverage. Variable cost is the cost that will increase or decrease in relation to sales. The more sale we make, the more variable cost we need to pay. On the other hand, fixed costs will not related to the output or sale. It will remain the same regardless of the total output.
So if a company spends most of the expenses on the fixed cost, it means they have a high operational gearing.
On the other hand, the company will have low operational gearing when they spend mostly on the variable cost rather than fixed cost.
Operational Gearing Formula
Operational Gearing = Fixed Cost/(Fixed Cost + Variable Cost)
Operational Gearing Analysis
High Operational Gearing Company:
The company is spending a huge percentage on the fixed cost, which is very risky for them. They have to generate a huge sale in order to cover the fixed cost otherwise they will be making a loss. Any change in sales will have a big impact on the net profit.
For example, in the transportation industry such as airlines, trains, and shipping, this industry will spend a large proportion on the fixed cost such as rental, depreciation, and so on. So they need to maximize their sale in order to maximize the profit.
Low Operational Gearing Company
Low operational gearing companies spend a large proportion on the variable cost rather than fixed cost. So if the revenue drop, the variable cost will eventually drop too, so it will have less impact on the net profit.
For example, the online store, spend very little on a fixed cost, but a huge amount on variable cost. They face a very low risk regarding fixed cost, as the variable cost will change depending on the sale.
Operating Leverage and Financial Leverage
Operating Leverage is the tool to measure company cost structure and the impact on it on the net profit. The company need generate a certain level of revenue to cover both fixed and variable cost, it is called the break-even point. Anything above that will be the profit.
Financial leverage is the tool to measure company debt and equity usage to fund the project and the impact of their costs. The company with high financial leverage will need to earn more to cover the cost of debt. The higher it gets, the higher risk it will face.