Operational Gearing Examples: How Fixed Costs Amplify Profit and Risk

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

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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