Greetings, everyone! In another episode of I Hate Numbers, your go-to for demystifying business finance, we unravel the intricate web of business costs and operational gearing.

Understanding Fixed and Variable Costs:

In the business realm, understanding your costs is pivotal for success. We're diving into two fundamental types: fixed and variable costs. Fixed costs, like the steady beat of a drum, remain constant, encompassing expenses such as salaries and rent. Meanwhile, variable costs fluctuate based on activity, akin to fuel consumption in a car.

Operational Gearing Unveiled:

Now, let's delve into the core concept of operational gearing—the intricate relationship between fixed and variable costs. This relationship profoundly influences the risk and profitability of a business. The higher the fixed costs in relation to total costs, the higher the operational gearing.

Scenario Analysis - Lower Operational Gearing:

Transitioning into our first scenario, with a 50% fixed cost burden, we'll explore the impact of a 20% sales fluctuation. Fixed costs stay static, but variable costs adjust accordingly. The result? A substantial profit increase, showcasing the dynamics of lower operational gearing.

Scenario Analysis - Higher Operational Gearing:

Conversely, in our second scenario, where fixed costs make up 60% of the total, we'll observe a more pronounced impact of a 20% sales fluctuation. The higher operational gearing leads to a more significant profit increase when sales rise but a more substantial decline when sales drop.

Key Takeaways:

So, what's the key takeaway? High operational gearing can be advantageous during growth but risky in challenging times. Being cost-conscious is crucial, offering a buffer against unexpected downturns.

Tools and Resources:

Furthermore, explore our Numbers Knowhow site for a free online calculator and other resources, including BudgetWhizz. Planning for the future? Dive into our online planning tool with a cash flow planner—your ally in business strategy.

Conclusion:

As we wrap up, remember to share this valuable insight with others. Your reviews and comments help expand our community. Until next time, happy calculating, and stay tuned for more business wisdom on "I Hate Numbers."

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.