Definition of Operational Gearing
Operational gearing can be defined as the impact of fixed costs on the relationships between sales and profits.
If the said company has no operational gearing, the operating profit is likely to increase at the same rate as the sales growth. Operational gearing is also referred to as operating leverage.
Therefore, operational gearing or operational level is defined as a cost-accounting formula that measures how a company can increase operating income by increasing revenue. Businesses with higher gross margins and lower variable costs have high operating leverage.
The main reason and rationale behind calculating operational gearing lie in calculating companies’ break-even points and helping them set reasonable selling prices to cover all costs to generate profits.
Companies with higher operating leverage are supposed to cover a more significant number of fixed costs every subsequent month regardless of the sales volume.
Lower operational gearing is typically distinctive of higher costs that vary directly with the sales volume but have lower fixed costs to cover every subsequent month.
The Formula of Operational Gearing
Operational Gearing (or Operational Leverage) is calculated using the following formula:
Operational Gearing = Contribution Margin / Net Operating Income
The Contribution Margin can be calculated as follows:
Contribution Margin = Price – Variable Costs
Alternatively, the following formula can also be used:
Operating Leverage = [Q * (Selling Price – Variable Cost)] / [(Q * (Selling Price – Variable Cost) – Fixed Costs]
Analysis of Operational Gearing
Operational gearing basically shows the impact on a firm’s earnings before interest and taxes as sales increase. This is mainly done using the formula above for the degree of operational leverage.
In the same manner, the degree of operational gearing is also resourceful in assessing the impact of fixed costs on the core operations of the business.
Higher operating leverages are considered favorable for most companies. This is because an increase in sales would increase revenues quite substantially.
For example, if the company has a degree of operational leverage equivalent to 1.5, an increase of 10% in sales would increase 15% in operating profits.
On the contrary, lower operating leverages are not considered favorable because the impact of the increase in sales on profits is insignificant.
This also implies that the fixed costs to variable costs are pretty high. Therefore, an increase in sales might not result in higher profits than higher operating leverages.
For example, suppose a company has a degree of operational leverage equivalent to 1.01. This means that an increase of 10% in sales revenue would result in 1% in profits.
Therefore, higher operational gearing is better as compared to lower operational gearing.
Implications of Operational Gearing
The degree of operational gearing can be defined as a multiple that measures how much a company’s operating income changes in response to the change in sales.
Companies that have a large proportion of fixed costs (costs that stay consistent, regardless of the level of production) to variable costs (costs that fluctuate with the level of output) have higher levels of operational gearing.
The DOL ratio, in this case, analyzes the impact of the change in sales on company earnings of profits.
The formula of operational gearing is used to calculate a company’s breakeven to help set reasonable selling prices so that all costs can be covered and the company can generate a good (or required) profit.
The formula used mainly reveals how well the company uses its fixed cost items, i.e., its overheads, to generate profits. The greater the extent to which the company is able to squeeze out of the same amount from fixed assets, the higher the operating leverage.
The conclusion that can be derived from calculating operating leverage is the fact that firms that can minimize their fixed costs (i.e., can keep their fixed costs to a reasonable level) can increase their profits without making any changes to the selling price, contribution margin, or the volume of sales that they have.
Example of Operational Gearing
The concept of operational gearing can be illustrated through the following example:
Harry Co. sells 500,000 units of a certain product at $5 each. The fixed costs incurred by the company are $500,000. The variable per unit cost of the product calculated by Harry Co. is $2. To calculate the company’s degree of operating leverage, the following formula is used:
Operating Leverage = [Q * (Selling Price – Variable Cost)] / [(Q * (Selling Price – Variable Cost) – Fixed Costs]
Operating Leverage = [500,000 * ($5 – $2)] / [(500,000 * ($5 – $2) – $500,000]
Operating Leverage = $1,500,000 / 1,000,000 = 1.5 or 150%
This implies that a 10% increase in the sales revenue will result in a 15% increase in operating income for Harry Co.
Examples of companies with High Operational Gearing and Low Operational Gearing
Companies that have higher fixed costs have higher operating leverage. This is pertinent to companies with the most research, development, and marketing investments.
With every dollar in sales revenue that the company makes over and above the breakeven point, the company makes a profit.
On the contrary, trading set-ups typically have lower fixed costs than retail stores. However, their variable costs are marginally high, primarily for merchandise.
Since retailers have a significant amount tied up in the form of inventory, their Cost of Sales increases as Sales increase, as a result of this, such companies have low operational gearing.
Advantages of using Operational Gearing
Operational Gearing is resourceful for the company because of the following reasons:
- Operational gearing helps companies realize and assess the ideal selling price depending on the fixed cost outlay.
- Operational gearing helps companies and external stakeholders (including shareholders and other decision-makers) assess the fixed cost outlay and how it can be further reduced if required.
- Investors also have an idea regarding the company’s actual financial position and its propensity to increase its profitability over time. It shows the impact of profits that result in the company’s growing revenue over time.
However, there are certain limitations of operational gearing which should be considered. These limitations are as follows:
- Companies with higher operating leverage are often vulnerable to the business cycle and overall macroeconomic conditions.
- The analysis of operational gearing (or degree of operating leverage) holds true if there is reasonable evidence that the company can regulate its demand. However, in most cases, generating sales demand is not entirely contingent on the company’s efforts. Specifically, during economic recessions, companies might not be able to increase their demand as significantly.