Like all managers you probably spend time forecasting cash flows and making a lot of plans based on these forecasts. For example, you need to forecast for any deals struck with third parties. Such deals happen years in advance, and if you quote prices in them, these will be based on costing forecasts that you have made in your budgets.
Forecasting is, of course, not easy and getting it wrong could lead to liquidity problems as well as volatility in earnings for the shareholders. This is where operating gearing comes in: the higher the operating gearing the higher this risk is! And it is good to know how this is calculated so you can see this for yourself.
An enterprise is highly operationally geared if a substantial proportion of its operating costs are fixed, no matter what the level of turnover is. During good times there are enough profits to pay for the fixed costs that are time-based (rentals of plant for example, salaries of specialists etc.) but during times when revenue is low, it becomes more difficult to break-even if fixed costs are high.
An enterprise with relatively low fixed costs is said to have low operational gearing and such companies run a lower risk of not being able to break-even during times of lower revenues.
An enterprise with trading costs that are directly proportional to turnover, and which are solely variable costs, has no operational gearing! An example could be someone that sells goods from door to door or sells goods in some town square until the police catch them and make them pay penalties! Or even if a trader were to rent municipality space to legally sell things in the town square, they are still operating on very low Operating Gearing as their fixed operating costs are not huge.
How do we measure operating gearing?
One way to measure it is simply to express fixed operating costs as a percentage of total operating costs. Another measure is simply the ratio of fixed costs to variable costs.
A more common measure of operating gearing is:
(PBIT stands for: Profits Before Interest Expense and Taxation)
PBIT + fixed operating costs = Profit before deducting fixed costs. In other words, the profit that is available towards fixed costs.
The more the fixed costs the higher the ratio (and the higher the ratio, the higher the risk!). In the extreme case of zero fixed costs, the ratio becomes 1, which means no operational gearing.
The effects of gearing
Gearing can magnify operating profits both ways (that is, up and/or down).
So just like financial gearing measures the degree to which a company faces financial risk (i.e., the risk that its share value will be affected), operational gearing provides a measure of the risk that changes in sales will have a magnification effect on profits that would be available to shareholders.
Let’s have a closer look at this with an example which will clarify everything:
Let's investigate operating gearing through the changes in a company’s cost structure and the impact this will have on the variability of earnings for shareholders.
We assume that currently, all costs are variable (rather extreme case!), running at 60% of turnover. This means that if there are no sales, we can avoid all costs, even wages!
However, staff are asking for a fixed salary, which would amount to 20% of projected and budgeted turnover (it may look “variable” but please note that it is a fixed and pre-determined tariff on the budgeted revenue!). We are also considering whether or not to substitute debt financing for some of the current 100% equity financing. This debt would give rise to a fixed interest charge amounting to 10% of current turnover.
Let us investigate the effect that a 10% drop in sales would have on earnings for shareholders as follows:
(a) under the current costs structure;
(b) after adopting the staff suggestion of fixed salaries;
(c) after adopting fixed salaries and the introduction of debt finance.
Assume that corporation tax is at 30% on profits.
(a) Current cost structure:
We see that under the current structure, net earnings move in the same direction and by the same % as total revenue:
(b) Adopting fixed salaries:
With salaries now fixed at 20, the variable costs become 40% of revenue (60 – the now fixed 20).
Degree of operating gearing (“DOG”) – due to all fixed costs other than debt interest payments
(c) Adopting fixed salaries and the introduction of debt finance:
Here the company has both operating and financial gearing.
Degree of financial gearing (“DFG”) – due to fixed costs of debt interest:
Degree of total gearing (“DTG”):
Note that: DTG = DOG x DFG
Note: Degrees of gearing are different at different levels of turnover. The higher the number, the higher the gearing.
Final note: What does the gearing number actually demonstrate? It is actually the number of times that income needs to cover the Fixed Costs. That is why when the DOG equation produces ‘1’, this means there is no gearing.
We have seen above how measuring operating gearing and knowing what contributes to it can help you in the decisions you make in budget forecasting among others.