Risk is a natural part of business life; using operational gearing measures one of those risks.  Sorry to throw in a bit of jargon there at the start, my jargon buster ray gun is there at the ready.

Have you ever wondered what operational gearing is? And how it can benefit your business? Maybe you have never heard of it.  Wonder no more, I look at operational gearing in this week’s podcast.  Firstly, I explain what operational gearing; secondly, how you measure it.  Finally, how you can use this knowledge to make your business stronger, with knowledge comes power.

Operational gearing is the level of fixed costs in a company as a proportion of total costs. It is a measure of how much a company has to spend to keep the business running, regardless of how much revenue it generates. The higher the level of fixed costs, the higher the operational gearing.

A high level of operational gearing can be risky for a company, because it means that a small decrease in revenue can result in a loss. However, it can also make a company more profitable because it can increase margins.

Understanding operational gearing is important for business owners and managers because it can help them to make informed decisions about where to allocate resources and how much debt to take on. It can also help them to understand the risks and rewards associated with different levels of operational gearing.

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Risk is an inevitable part of any business, we can't avoid it. It's there. And one particular risk that we as business owners need to face is that risk due to our cost structure. In this week's I Hate Numbers Podcast, I'm going to be talking specifically about operational gearing, what it is, why it's important for your business, and why it also presents an opportunity for you as well as being aware of the pitfalls and the trip ups it can make in your business.

You're 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.

Hi, folks. My name is Mahmood. I'm an accountant, mentor, proud author of the book I Hate Numbers and the purpose of my business, the purpose of my podcast is to help you improve your financial awareness, help you win more battles than you lose between your ears, and help you and your business, more importantly, make profits, save time, save tax, and have the business that you aspire to have. What's not to love about that? Let's crack on with this week's podcast.

Risk, as I said, is an inevitable part of our business life. And when we look at generating profits, when we look at the underlying basis here, one thing we need to be fully aware of is the cost structure that we have. Now, operational gearing, to give it its posh term is that relationship that measures the risk due to the type of costs that we have in our cost structure. For our American cousins listening in, gearing is normally referred to as leverage. So if you hear the word gearing, it has nothing to do with vehicles or cars, is to do with that risk measure.

So operating gearing and leverage is what we're going to be talking about in this week's podcast. Before we dive deeper to look at the impact of operational gearing and how we measure it, let's first of all revisit and look at what is the types of costs that you're going to have in your business. Now, costs broadly fall into two broad camps. You have your fixed costs, and those fixed costs are costs that are committed, they're non controllable, and they remain constant irrespective of your business activity.

Variable costs are those ones that will fluctuate according to how much work you're doing, how much business activities you undertake. A good example of that would be a business that needs to use personnel in its business. And it has two choices. It either employs somebody under a salary scheme under PAYE, as we would call it in the UK, put them on the books, as you might call it, or you engage the services of a subcontractor, a freelancer. Now, if we take on an individual to be part of our team as a salaried employee, then that cost becomes fixed.

So whether we have no work coming into our business, we still have to honour and pay the wages of that individual. If you engage a freelancer, if you have no work in the pipeline, have nothing to carry out, then you're not committed to actually pay that freelancer. In that context, your freelancer is a variable cost and your salaried employee is a fixed cost. There are other examples that we can dive into and to have a look at. If you're a restaurant, the cost of the food ingredients that you buy in is classified as variable.

The amount you're buying overall will be determined by how many customers come into your restaurant, the rent you pay on the restaurant, the salaries of your staff, the depreciation, the back office functions will typically be fixed in nature. Having set out the different types of cost here, the operating gearing, first of all is the relationship with the overall costs for your business. How much that is made up of fixed and how much is made up of variable. The higher the level of fixed costs in that cost structure, then you're more geared in operational terms. The lower the level of fixed costs, then you have a low level of operational gearing.

Now folks, if you're listening to this, thinking all these numbers, how do I do the number crunching? Fear not, check out the show notes and I've got a link to a wonderful free online calculator which does the heavy lifting for you. You just punch in your numbers. Literally, once you press that send button, the results will appear in front of you. Now, let's carry on where we left off. Now, having determined what operational gearing is, it's the relationship between fixed costs and the overall cost structure, the next thing we've got to think is in terms of what does it actually mean. Now, risk is a big and scary word, but it's something that all companies, all businesses will face. Whether you are an acorn sized business, an oak tree sized business, whether you're a service business, social enterprise, a private business, it makes no difference.

Everybody has fixed costs, everybody has variable costs. And therefore levels of operational gearing will change according to the sector and the business that you have. Now, the reality will be as follows. If we see a drop in income, the level of sales that we're generating fall, if your business is highly geared operationally, so you've got a high level of fixed costs, then it could be squeaky bum time. What that means is, as sales drop, those fixed costs will not be afforded in the short term and very soon you could be hitting that loss making situation and the level of profitability will decline quite rapidly.

If you've got low operational gearing so you don't have a high burden of fixed costs, then that drop in demand, that drop in sales will not have the same dramatic impact because as activity sales declines, then your level of costs, which are largely variable, will decline in line with that. Now perversely, let's flip it on its head. If your business activity, your forecast, your demand, the level of sales that you're likely to make is going to increase, that's actually going to be a beneficial, a Brucey bonus for you if you're highly geared operationally. Because the level of sales that you make, your underlying fixed cost will stay static.

Imagine that situation. You've got an employed member of staff. If you manage to increase your turnover by 20% or 30%, their underlying salary remains the same. What you're going to experience is something called economies of scale. Those salary costs remain constant and therefore you generate a higher level of profit and that profit is there as for you to do with what you wish. Conversely, if you've got a high dependence on variable costs, so you rely on a lot of freelancers, subcontractors, those variable costs constitute a high proportion of your cost base, as you make more money,

then a lot of that money will be used up in servicing and paying for those variable costs. So you won't see a dramatic benefit coming forward. So even though the risk levels are high and high operational gearing, it doesn't mean it's necessarily bad. And we can use that information in a variety of cases. We can use it when we're running our business. We can determine the level of business risk that we're taking. We can therefore see in terms of the impact on our planning cycle, our forecasting, where we are likely to end up when we move demand upwards and paradoxically, when we move downwards, we can see what the effect is as well.

Investors, by the way, if you're looking to invest in another company, you want to see what the underlying performance of the company is, then examine what the cost structure is, see where you are there and that will give you some insight to the volatility of that company's performance. Let's roll up what we've got here, folks. So we talked about operational gearing. What is it? Well, it measures risk, but it measures risk according to your cost structure. The higher the level of fixed costs and your total costs, then you're highly geared operationally, the lower the proportion of fixed costs, then you've got lower operational gearing.

Now, high or low in itself doesn't mean anything. It's really about contextualising that and what's the impact? Where do you see yourself as your demand, your sales goes forward? Now, if times are rough and you anticipate a drop in sales, then you need to rethink about your cost structure and are there fixed costs that you can either reduce offload or can you convert them into variable type costs? You may decide to swap salary costs and substitute that with freelancing costs. Now that's not an easy thing to achieve, but it's something that your brain should be connected to and what you should be thinking about.

All these things plug into your planning cycle. And as you know, folks, if you've listened to the podcast, I'm a big fan of planning here. And when we forecast and plan, being aware of that operational gearing impact is great for seeing where we're likely to end up. Check out the show notes, folks, and you can see that link to an online calculator. Also check out the link to the Numbers Know How platform, where we've got a wonderful financial planning community for you to join into.

If you've got some value out of the podcast, which I hope you do, I'd love it if you could go share that, subscribe or even leave a comment and a feedback, and that would really help make it easier to share this podcast with others. If you got thoughts for what you’d like covered on a future podcast, then by all means, be free to leave me a comment, send me a message. Until next week, folks, be sanguine.

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.