� Operational Gearing 2
�
Operational gearing is the effect of fixed costson the relationship between sales and operating profits. If there isno operational gearing, then operating profit would rise at the same rate as sales growth( assuming nothing else changed).
� Operational gearing is simple and important- and often neglected.
� High fixed costs increase operational gearing.
Consider the following example:
1. Two enterprises with different cost structures but the same profits
2. Now suppose they both increase their sales by 50 %
Enterprise A Enterprise B Enterprise A Enterprise B
Sales 1,000,000 1,000,000 1,500,000 1,500,000
Variable Costs 700,000 800,000
( 700,000 + 350,000) 1,050,000
( 800,000 + 400,000) 1,200,000
Fixed Costs 200,000 100,000 200,000 100,000
Operating profit 100,000 100,000 250,000 200,000
As Enterprise A has higher operational gearing, it makes 2.5 × as much profit as it did before the 50 % increase in sales, whereas Enterprise B has only doubled its profits.
If you have time in the session, this could be a good exercise for participants to experiment with as it will contribute to sales / membership planning of the social start up and the potential profitability for it and its members.
If there is no time in the session, then do ask the Finance Team to work on this before the next Session.
2 This section is adapted from http:// moneyterms. co. uk / operational _ gearing /
60