chpt 13 – capital structure & financial ratios

With high fixed costs a (for example) 10% growth in sales will increase total revenue by 10% but the profit will increase by more than 10%.
Similarly, if there is a 10% fall in sales, the total revenue will fall by 10% but profit will fall by more than 10%.
If you have a god at example 3 in the chapter then you will see what I mean.

In example 3, for A if sales volume grows by 10%, then both the revenue and the variable costs will grow by 10% as well. However because the fixed costs remain unchanged, the profit will actually grow by 12.5%.
Similarly with B, growth in sales volume is 10% but because there are lower variable costs and higher fixed costs, the profit grows by 20%. (The workings are all in the lecture notes).

So in times when sales volume is growing, it is better to have more fixed costs and fewer variable costs, because it will mean higher % growth in profits.

However, when sales volume is falling, higher fixed costs means bigger % falls in profits, so it is better to have fewer fixed costs and more variable costs.

The logic is identical to financial gearing except that with financial gearing the fixed cost is due to the interest being paid, whereas with operational gearing it is due to the way they structure their costs.

Companies have the choice with many of their costs (not all, but many of them) as to whether to have them as fixed costs or as variable costs.
For example, a teaching college could employ their teachers on fixed salaries (so a fixed cost) or could use them ‘freelance’ and just pay then a rate per day for days they actually teach (so a variable cost).

No – it is not an assumption, it is a fact 🙂