What is Operational Gearing?

Broadly speaking, companies have two types of costs; Fixed costs and Variable costs.
- Fixed costs are incurred regardless of the level of output (i.e. even when there is no production these costs are incurred). A common example is rent
- Variable costs vary with output as the name suggests. Generally, as output increases so do variable costs. These costs may include raw material costs or electricity costs

Understanding the relationship between fixed and variable costs is important, and that will become apparent later. The relative proportions are shown by a company's Operational Gearing. The relative levels of fixed and variable costs is largely dependent on the industry in question. High operational gearing says that fixed costs are a high proportion of total costs, whereas low operational gearing says that fixed costs are a low proportion of total costs.

Sectors associated with relatively high fixed costs compared to variable costs include airlines and hotels. It is intuitive because airlines, for example, carry the vast majority of the cost in using the plane compared to the relatively small variable costs such as on-flight catering (which are not included since the advent of budget airlines such as EasyJet).

Example

The best way to understand operational gearing is to look at an example. Company A has high fixed costs relative to variable costs whereas Company B has low fixed costs relative to variable costs. The impact of a 20% rise in revenues has a profound impact on the relative profits of the companies.


If it is not immediately obvious what is going on, here is an explanation. There are two companies, A and B. They have the same number of shares in issue and have to pay the same corporation tax rate. In Year 1 both companies are making £50m in revenues although Company A has far more fixed costs than variable, compared to Company B. In other words, Company A has a high operational gearing whereas Company B has a low operational gearing. That mixture of costs makes a difference. Anyway, both companies make a pre-tax profit of £10m which is £8m post-tax. Divide by the number of shares in issue and the EPS is 6.67p for both.

In Year 2, both companies experience an uplift in revenues of 20% through increased sales volumes. Remember that only variable costs vary with output (sales volumes), so these increase by 20% as well. The fixed costs don't change. This leads to Company A making pre-tax profits of £19m vs. Company B's £13m. So a 20% change in revenues can have a disproportionately larger impact on profits for companies that have high operational gearing (Company A) compared to those who have a lower operational gearing (Company B). This filters through to the EPS changes which are 90% and 30% respectively.

There is also a change on the gross margin achieved by the companies. In the first instance, the gross margin for both companies is 20% (10/50 * 100). After the revenue rise, the gross margin for Company A rises to 32% and the gross margin for company B rises to 22%.

However...

Whilst this is good news when a highly geared sector is recovering, it's bad news when the sector is declining. The reason is that the process reverses and a small reduction in revenue can lead to a much larger reduction in profitability. These shifts in profitability mean that EPS figures tend to fluctuate much more wildly, and so do the share prices of these companies. The share prices are likely to yield bigger swings between sector upturns and downturns. Bear in mind that the market prices these profitability swings, in to some extent. This does mean though that if a highly operationally geared company signals that it is going to significantly beat revenue expectations, the impact on profits will be large, and there could be an opportunistic investment period whilst the market adjusts to a higher level.

It's also worth recognising that this is a simplistic model. For example, when companies grow their fixed costs have a tendency to rise (e.g. a company may acquire a new office which increases rent). Note that this effect is not the same as a product price rise. If a gold production company increases revenues from a higher gold price rather than a change in output, then variable costs will not rise and the bottom line (profitability) would rise even faster. The concept of operational gearing is nonetheless an important concept that investors in income generating stocks should look to grasp.