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Hi,
Just wondering if operational gearing when taken as contribution over PBIT would give a % like financial gearing or is it an absolute figure?
I’m also wondering what would constitute a high or low operational gearing figure based on contribution/PBIT?
I get in general if contribution is high and PBIT low then it would mean high fixed costs, only just covered by contribution but what is the point when a company goes from low geared to highly geared with this ratio?
If it’s a % like financial gearing is it the same where over 50% is highly geared and under is classed as low geared?
Cheers
LouiseIt will be a proportional/percentage figure.I don’t much like the calculation using contribution/PBIT (high = relatively high fixed costs) and prefer using fixed costs/total costs as it seems plainer to me.
At one level there is no difference in the interpretation of financial gearing and operation gearing. High financial gearing mean that the company is burdened with high interest costs (which must be paid – ie they are fixed); high operation gearing also means that the company is burdened with high fixed costs (such as rent). In both cases, high gearing means that if contribution falls a little it might be difficult to meet the meet the fixed costs – whether they are interest costs or other fixed costs.
I am reluctant, at the APM level to quote a high/low percentage as it depends on the nature of the company’s business. If a company owned 100 apartments which it rented out on agreements of at least a year, then its income is very predictable over months and maybe even years. It can therefore take on more fixed costs as it is relatively confident that rents will cover these.
However, if the company is fast moving consumer goods then demand can quickly fall off, contribution is volatile so gearing, of both types, should be lower to build in some safety.
High operation gearing implies high fixed costs and these are often found in businesses that are highly automated (machinery and the factories impose mostly fixed costs). If sales volumes rise then profits rise rapidly because most costs, apart form material, will be constant.
Dear Sir,
Related to this question, what practical steps could a company that is highly geared (operationally) take then to reduce its level of fixed costs proportion?
I know that for a high financial gearing, reducing the level of debts (interest payments) could bring this down but for a high fixed cost say in rents or salaries or the machines you mentioned above, how could a company go about bringing reducing these costs without laying off the staffs to reduce salaries for instance?
Thank you.
The usual way would be to get rid of some assets, such as a factory, delivery vehicles and machinery, then to subcontract for manufacturing and logistics. Subcontracting charges can be on the basis of production.
Reducing fixed salaries is often part of reducing fixed overheads.
Ok thank you, so for a question on operational gearing it would be OK to use the ratio of fixed costs as a % of total costs and talk about that in my answer obviously linking it to the scenario.
That’s what the answer to Coal Creek 12/12 did, but the BPP text book did not mention that ratio in relation to operational gearing so I figured in general it would be better for me to use contribution over PBIT, but happy to use fixed costs/total costs if that will be accepted generally too.
Thank you!
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