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Hi John
I am a bit baffled by the constant chopping and changing of the examiners definition of operation gearing
So far I have seen
Fixed costs/variable costs
Fixed costs /total costs
Sales/fixed costs
Contribution /profit before interest and tax! (bpp revision kit page 168 q63.1)Is there anyone you would recommend or is there any way to ascertain which one he is referring to, its a bit frustrating!
Cheers
Hugh
All of these will give an answer, and u can use any of these depending on the data the questioner gives
There is no standard measure – you can use several.
All that matters is that you are able to explain that it is the level of fixed operating costs that creates the operational gearing.
Hi John,
I still cannot seem to understand the similiarity of the logic behind these two formulas to get the operational gearing.
1) Fixed costs/Total and 2) Contribution/PBIT
The formula should be giving you the extent to which the operating costs of a company are fixed rather than variable.
I undersand this from formula (1) but not from formula (2).
Am i suppose to assume that contribution is a fixed cost?(Which does not make scence to me as it not a cost in the 1st place).And PBIT is representing what exactly?Please help.
The better of the two measures is contribution / PBIT (which is profit before interest and tax).
The reason is that as the contribution changes (due to higher or lower sales) then so to will the profit (which is the contribution less the fixed costs).
However the greater the fixed costs, then the more the profit will change as the contribution changes. (If the contribution falls by 10%, then if there are no fixed costs then the profit will fall by 10%. However if there are fixed costs then the profit will fall by more than 10%, and the more the fixed costs the more the fall in profit.
(Have a look at example 3 in chapter 13 of our free lecture notes and you will see what I mean.)The reason we are concerned about gearing (whether financial or operational) is because higher gearing makes the profits (and therefore ultimately the dividends) fluctuate more and therefore more risky.
With financial gearing it is due to the fixed interest payable each year, with operational gearing it is due to the fixed operating costs each year.Our free lectures on Chapter 13 will help you as well.
(Our free lectures are a complete course for Paper F9 and cover everything needed to be able to pass the exam well.)
Fantastic explanation!
A wholly satisfying answer!Maybe I can pass the exam, even get a job and have a succesful career without ‘deeply’ understanding the in and out and the nitty gritty of the formulae and similar items….
But when these so called ‘teeny weeny’ doubts/confusions are cleared up, you really appreciate the wisdom and logic behind them.
They put things in a new light and that improved perspective helps to further learn or implement knowledge with more enthusiasm and confidence… and NOT because the TEXT/TEACHER said so.An overwhelming sense of gratitude and amazement rushes through me and this is a feeble effort to convey it in words.
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