Operational gearing

Operational gearing is the effect of fixed costs on the relationship between sales and operating profits. If a company has no operational gearing, then operating profit would rise at the same rate as sales growth (assuming nothing else changed).

Operational gearing is simple and important - and often neglected.

High fixed costs increase operational gearing. Consider two companies with different cost structures but the same profits.

	Company A	Company B
Sales	1,000,000	1,000,000
Variable Costs	700,000	800,000
Fixed Costs	200,000	100,000
Operating profit	100,000	100,000

At this point both companies have the same sales and the same costs, and therefore the same operating profit.

Now suppose both companies increase sales by 50%

	Company A	Company B
Sales	1,500,000	1,500,000
Variable Costs	1,050,000	1,200,000
Fixed Costs	200,000	100,000
Operating profit	250,000	200,000

The company with the higher operational gearing, A, makes 2.5× as much profit as it did before the 50% increase in sales, whereas B has only doubled its profits.

Operational gearing is this effect on operating profit. There is a further similar effect on pre-tax profit as a result of the level of interest a company has to pay (another fixed cost), this is financial gearing.