Operational gearing helps us understand how the mix of fixed and variable costs can magnify changes in business profit.

Two businesses can have the same sales, the same total costs and even the same starting profit, but react very differently when sales rise or fall. The difference can come down to how much of the cost base is fixed.

In this episode, we use two practical operational gearing examples to show why a business with more fixed costs can benefit more when sales grow, but also experience a sharper fall in profit when sales decline.

About this episode

Understanding costs is not just about knowing how much money leaves the business.

We also need to understand how those costs behave.

Some costs remain relatively stable when activity changes. Others rise and fall with sales, production or delivery.

The balance between those two types of cost affects how sensitive our profit is to changes in sales. That relationship is what operational gearing helps us understand.

If you want the foundation first, see our guide to what operational gearing is.

Fixed costs: the steady drumbeat

Fixed costs are the steady drumbeat in the business.

They are costs that do not usually move in the short term simply because activity goes up or down.

Examples can include salaries, rent and other commitments.

If you run a theatre, those costs are still there even when seats are empty. If you manufacture products, they remain even when production slows. If you run a consultancy, the commitments continue whether the diary is full or quiet.

That does not mean fixed costs remain unchanged forever. It means they are relatively fixed within the period and level of activity we are considering.

Variable costs move with activity

Variable costs behave differently.

Think about fuel in a car. If the car stays parked, very little fuel is consumed. Once we start driving, fuel use increases with the journeys we make.

The same idea applies in business.

A theatre may use freelancers when a show takes place. A manufacturer may use subcontractors when production increases. A retailer uses more stock as more products are sold.

No activity means little or none of that particular variable cost.

So while fixed costs stay relatively static, variable costs move with the activity that drives them.

What does operational gearing tell us?

Operational gearing looks at the relationship between fixed and variable costs and what that means for business risk.

As a general principle, the greater the proportion of fixed costs within the overall cost structure, the higher the operational gearing.

A business with a lower proportion of fixed costs has lower operational gearing.

Neither is automatically good or bad.

The real question is what happens when sales change.

Operational gearing example 1: lower fixed costs

Let us start with a business producing sales of £25,000.

Its costs are:

• Variable costs: £10,000
• Fixed costs: £10,000
• Total costs: £20,000
• Profit: £5,000

Fixed costs therefore make up 50% of the total cost base.

If sales increase by 20%

Sales rise from £25,000 to £30,000.

The fixed costs remain at £10,000, while the variable costs rise by 20% from £10,000 to £12,000.

Profit becomes:

£30,000 sales - £12,000 variable costs - £10,000 fixed costs = £8,000 profit

Profit has increased from £5,000 to £8,000, a movement of £3,000.

If sales decrease by 20%

Sales fall from £25,000 to £20,000.

Variable costs fall to £8,000, but fixed costs remain at £10,000.

Profit becomes:

£20,000 sales - £8,000 variable costs - £10,000 fixed costs = £2,000 profit

This time profit falls by £3,000.

Operational gearing example 2: higher fixed costs

Now let us keep the starting sales, total costs and profit exactly the same, but change the cost structure.

• Sales: £25,000
• Variable costs: £8,000
• Fixed costs: £12,000
• Total costs: £20,000
• Profit: £5,000

This time fixed costs make up 60% of total costs.

The business therefore has higher operational gearing.

If sales increase by 20%

Sales again rise to £30,000.

The fixed costs stay at £12,000. Variable costs rise by 20% from £8,000 to £9,600.

Profit becomes:

£30,000 sales - £9,600 variable costs - £12,000 fixed costs = £8,400 profit

Profit has increased by £3,400.

That is a bigger improvement than the £3,000 increase in our first example.

If sales decrease by 20%

Now sales fall to £20,000.

Variable costs fall to £6,400, but the £12,000 fixed cost burden remains.

Profit becomes:

£20,000 sales - £6,400 variable costs - £12,000 fixed costs = £1,600 profit

Profit has fallen by £3,400.

Again, that movement is greater than in the lower operational gearing example.

Comparing the two examples

Scenario50% fixed costs60% fixed costs

Starting profit

£5,000

£5,000

Profit after 20% sales increase

£8,000

£8,400

Profit increase

£3,000

£3,400

Profit after 20% sales decrease

£2,000

£1,600

Profit decrease

£3,000

£3,400

The starting profit is identical in both businesses.

However, the business carrying the larger fixed-cost burden experiences a greater movement in profit when sales change.

That is operational gearing in action.

Why higher operational gearing can be good

Higher operational gearing can work strongly in our favour when sales and activity are growing.

The fixed cost is already committed. Therefore, once additional sales cover the associated variable costs, more of the extra income can flow through into profit.

This is also where economies of scale become relevant. Fixed costs can be spread across a greater level of activity, reducing the average cost of producing or delivering each unit.

So a higher fixed-cost structure can be powerful when the business has the sales volume to support it.

Why higher operational gearing increases risk

The same mechanism works in reverse when sales fall.

Variable costs may reduce with activity, but fixed costs remain.

That means profit can decline faster in a highly geared business.

A business with a heavy fixed-cost burden therefore needs to understand how much sales it needs to cover those commitments.

Our guide to break-even looks at the point where income is enough to cover the costs of the business.

Be cost conscious in good times as well as bad

Cost awareness is not something we should suddenly discover when sales start falling.

It matters when the business is stable and when it is growing too.

High fixed costs can support strong profit growth, but every new fixed commitment also changes the risk profile of the business.

Before adding premises, employees, equipment or other long-term commitments, think about how comfortably the business can carry those costs if activity does not meet expectations.

This is not about avoiding fixed costs. It is about understanding what they mean for the numbers.

FAQs

What is operational gearing?

Operational gearing describes how the balance between fixed and variable costs affects the sensitivity of business profit to changes in sales or activity.

What causes high operational gearing?

A business has higher operational gearing when fixed costs make up a larger proportion of its overall cost structure.

Is high operational gearing good or bad?

It depends. Higher operational gearing can increase profit more quickly when sales rise, but it can also make profit fall more sharply when sales decline.

Why do fixed costs increase business risk?

Fixed costs generally remain even when activity drops. This means the business still has to carry those commitments when revenue is lower.

What is the difference between fixed and variable costs?

Fixed costs remain relatively stable over a given period, while variable costs move according to an activity such as sales, production or delivery.

How does operational gearing affect profit?

Higher operational gearing magnifies the effect of changes in sales. Profit can increase faster when sales rise and decline faster when sales fall.

Episode Timecodes

• 00:23 - Introducing operational gearing
• 01:07 - Fixed costs and variable costs
• 01:59 - Why understanding costs matters
• 02:21 - Fixed costs as the steady drumbeat
• 02:58 - Variable costs and the fuel analogy
• 03:59 - What operational gearing means
• 05:28 - Lower operational gearing example
• 07:06 - Higher operational gearing example
• 08:39 - What higher gearing means for growth and risk
• 09:21 - Why cost consciousness matters

Related episodes and guides

• What Is Operational Gearing?
• Break-Even: An Important Business Milestone
• Economies of Scale: Definition, Benefits and Challenges

Key takeaway

Operational gearing is really about understanding how your cost structure changes your business risk.

More fixed costs can work strongly in your favour when sales grow because those costs do not rise at the same rate.

However, the same fixed-cost burden becomes more challenging when sales fall.

So do not look only at how much your business costs. Look at what type of costs you have, how they behave and how your profit responds when activity changes.

Know your fixed costs. Know your variable costs. Then test what happens when sales move in either direction.

Plan it, Do it, Profit.

Further Support

If you want to explore different cost, profit and planning scenarios, use our free online business calculators.

If you need help understanding your costs, profit, financial planning or wider business numbers, you can contact us for an initial chat.

You can also watch more practical finance and business support on the I Hate Numbers YouTube channel, or listen and follow on Apple Podcasts.

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Hi, everybody. Welcome to I Hate Numbers. This is the podcast that makes business finance simple and stress free, free of jargon, free of anxiety. I'm Mahmood, your business finance fixer, author, and tax advisor, and I'm here to help you understand your numbers and help you build a better business. Now in this week's episode, I'm going to be diving into the world of costs.

I'm going to be looking at something called operational gearing. Isn't that a phrase to conjure up with? And if you're in business, figuring out what's the relevance of your costs, what are your costs and what do you do about them, then this one is for you. Let's crack on.

You are listening to the I Hate Numbers Podcast with Mahmood Reza. The I Hate Numbers podcast mission is to help your business survive and thrive by you better understanding and connecting with your numbers. Number love and care is what it's about. Tune in every week. Now, here's your host, Mahmood Reza.

Now during this podcast, I'm going to explain the key difference between something called fixed costs and variable costs - I'm going to be looking at a concept and a practical application of Operational gearing and I'm going to illustrate that through the podcast a couple of scenarios Which uses this information and the impact on the profitability of your business. Now if you're sitting there thinking, oh my gosh, we've got numbers to listen to there is a link to a very helpful online calculator which does the heavy lifting for you,

which takes all the stress and the scratching your head out the number crunching and gives you that, gives you those figures in a usable format more of that towards the end of the podcast. Now if you're in business, whether that's a private business a creative business, it matters not. It's really crucial that you have an understanding of the costs in your business.

If not, you're going to be missing out on opportunities as well as heading towards financial catastrophe and financial headaches. And the two ways that I want to look at costs today, the two types are what are called fixed and variable. So what do we mean by fixed costs? Well, fixed costs are like those steady drumbeat in your business.

Whether you're a performing company selling tickets, they're still there. If you're a manufacturer making products, a consultant running a business, you will have costs that will be committed. You have costs that will not change irrespective of what you do in your business. So think salaries for your staff team, think rent on your building

and other commitments. And when nobody turns up to see your show, when products aren't manufactured, customers aren't buying your product, your theatre seats are empty, these costs will not move, these costs will not budge in the short term. And short term by the way is typically anything up to six months to a year.

Now that's fixed dealt with, what about variable costs? Now, I like to think of variable costs as costs that fluctuate. What do they fluctuate according to? Well they fluctuate according to an activity movement, an activity driver. Think of it this way, if you're a car driver, when you put that petrol in your car, that petrol will not be consumed

until you start driving the car. So the costs of fuel for your vehicle will fluctuate according to the distance you travel, the journeys that you undertake. Very similar in the context of a theatre company, a dance company. Take your pick. The artists that you use for the show, the freelancers. If there's no show, there's no freelancer costs.

If you're a manufacturer who uses subcontractors as part of their workforce. No manufacturing, no necessity to use that particular resource. Then you don't have subcontractors. If you're a retailer, if you run a concession stand, if you've got merchandising, no customers means no stock costs will be consumed.

Now these costs will fluctuate based on what you're up to. No shows, no activity, no variable costs. Now having dealt with those two different types of cost, both fixed and variable. I'm going to introduce something now called operational gearing. Now the relationship between fixed and variable costs is about the relationship, the understanding of risk in your business.

All business has risk. One of the key risks is how your costs are put together. The cost structure. of your business. Now you don't need to be an accountant, by the way, to get your head around this. It's just appreciating and being aware of what's going on. Now, as a general rule, the higher the level of fixed costs you have in your business in relation to your total costs, then you've got a high level of operational gearing.

The lower the fixed cost component of your business costs, then you've got a lower level of operational gearing. The key thing is, is it good to have high operational gearing or is it bad? And the classic answer for most people in the finance world is it depends. I'm going to illustrate that with a couple of scenarios. I'm going to keep the numbers deliberately small. That way our heads can get around that and as I said if you want to check out the show notes the link to an online calculator you can crunch those numbers and you can see what the results are of various scenarios. So here's our scenario the I HateNnumbers business has total sales of £25,000.

Now those sales could be historic or they could be ones we're putting into our budget. The variable costs of that business are £10,000 and the fixed costs are also £10,000. So we have overall 20,000 pounds worth of costs split between £10,000 of fixed and £10,000 of variable. If we were going to be looking at operational gearing, we would say that the fixed costs represent 50 percent of the total cost burden.

Now, what would happen if we had a 20 percent fluctuation in our sales line? Now, based on the relationship between fixed costs and sales, if the sales line went up by 20%, to say £30,000, those fixed costs would remain unaltered. The variable costs would move upwards by a factor of 20%, and that would be £12,000.

In essence, the profit has moved from £5,000 to £8,000, an increase of £3,000. Ka ching. Now what would happen if it went the other way? If the sales line declined, revised sales would be 20,000. The variable cost would drop by a magnitude of £2,000, but your fixed costs would stay the same. The overall profit in this case has dropped by £3,000.

So in that cost structure, a movement of 20%, it moved our profit figure by 3,000 pounds. Now what would happen if we change things, mix things up a little bit, and look to a different cost structure? Now what we can have in this scenario is instead of having 10,000 pounds worth of fixed costs, it's going to be 12.

The variable cost will be eight. So the overall costs remain the same at 20, but this time 60 percent of our costs are fixed and 40 percent are variable. It's got a high level of operational gearing. Now let's see what the impact will be by 20 percent movement on sales, both going up and then coming down.

What's your thoughts? What's your prediction? Before we crunch the numbers as to what's likely to happen? Now, in this second scenario, if sales goes up by 20%, the fixed costs remain the same. They're static. Our variable costs will move by 20 percent from 8,000 to 9,600. And overall, profit has increased by 3,400 pounds.

In scenario one, where the operational gearing was lower. The profit movement was three. In a second scenario where the operational gearing is higher profit moves up at a greater level. Now let's see what happens if it's the other way around. Our sales line drops by 20 percent and that could be for reasons of competition.

That could be reasons as we haven't realised our expectations. Now, the fixed costs remain the same 12,000 pounds. The variable costs would drop by 20 percent of the eight and they would drop to £6,400. Overall, our profit has declined by 3,400 pounds. Now, if we compare that to scenario one, a higher level of operational gearing means that our profits have dropped now more than they did in scenario one, where we had a lower level.

So what's the takeaways? What's the conclusions we can draw? If you've got a high level of operational gearing, i.e. you carry a high burden of fixed costs, whether they are for supporting the business, part of the manufacturing process, part of the delivery mechanism, then that's positive as long as the activity, the sales line, making more product is on the up and up.

You get what we call economies of scale. And I'm going to dive into that concept in a future episode. Now, conversely, if you've got a high level of fixed costs, what that means is if you're facing challenges on the sales line, if you're producing less product, there's a greater level of risk and your profit decline will be much greater.

Now, another takeaway. It's absolutely crucial to be cost conscious, not just in terms of times when things are challenging, but even when things are stable or even growing. High fixed costs can be great if there's a growth expectation, but they can be a challenge if things are getting tough. Now folks, please do check out the free online calculator on the Numbers Knowhow site, our sister company, which has got BudgetWhizz, a whole host of other resources here, and if you're into planning and why not, then that online planning tool, the cashflow planner is going to be a fantastic thing for you to dive into.

So check it out. Have a look. There's a free trial. I hope you've gained some valuable insights into understanding your costs. Check out the online calculator. And if you found this useful, I'd love it if you could share it with those who you feel would benefit. Hey. Give us a review. Give us a comment. It always helps to expand the audience reach and until next time folks,

happy calculating! We hope you enjoyed this episode and appreciate you taking the time to listen to the show. We hope you enjoyed this episode and appreciate you taking the time to listen to the show. We hope you got some value. If you did, then we'd love it if you shared the episode. We look forward to you joining us next week for another I Hate Numbers episode.