Operational gearing

Operational gearing seeks to measure the proportion of fixed cost to total operating cost. If the proportion of fixed cost is higher, it signals the business is operationally geared, which is not considered the desired cost structure from a financial performance perspective.

Why higher operational gearing is not desirable?

Increased business risk—The higher proportion of fixed costs reflects the business’s need to generate a certain level of sales to cover the fixed cost. It might be difficult for the business to reach the sales threshold in each accounting period. Similarly, a small decline in revenue might be sufficient to convert the profit to a loss.

Hence, the business risk is higher when operational gearing is higher.

Higher breakeven point—To reach a no-profit, no-loss state, businesses with higher operational gearing have to sell a larger volume of products/services. Reaching a higher sales volume can be challenging when business product is out of season. Hence, higher operational gearing is not desirable for the business.

Reduced flexibility—Operationally geared businesses are considered less flexible. They have limited flexibility in terms of adopting market challenges and emerging business trends as they are unable to take chances with their current operational capacity. Hence, businesses with higher operational gearing are expected to have less flexibility.

Higher risk for lenders and investors—Investors are less attracted to operationally geared businesses. They understand that fixed costs have to be incurred first. So, there may not be sufficient profit for the investors. Hence, businesses with higher operational gearing are not desirable from an investor perspective.

Formula

Operational gearing = Fixed cost / Total cost

Example of calculating operational gearing

ABC company’s profit and loss statement shows that the total fixed cost for the accounting period amounts to $20,000 and the total cost amounts to $40,000. In this case, operational gearing can be calculated as follows.

Operational gearing = Fixed cost / Total cost

= $20,000 / $40,000

= 50%

Is operational gearing the same as financial gearing?

Operational gearing refers to the proportion of the cost structure in terms of fixed cost. If fixed cost is higher, the gearing is expected to be higher, and vice versa. On the contrary, financial gearing refers to the proportion of debt to equity. If the proportion of debt is higher than equity, it signals higher financial gearing and vice versa.

Conclusion

Operational gearing measures the proportion of fixed costs in comparison to total costs. Businesses with higher gearing are considered to carry significant investment risk.

These businesses face limited flexibility and limited investor confidence. However, these are not the sole grounds for assessing the financial performance of the business.

Financial gearing is different from operational gearing. Financial gearing measures the proportion of debt in relation to business equity.