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Hello Again
I am a bit confused about the purpose of the operational gearing ratio and how we are told to calculate it.
I can remember reading in an article or a question where they justified the business risk by just comparing Fixed costs over variable costs of a company. However in question (Freeze) they use contribution over PBIT adding the revenue, hence another variable into the equation. I thought operational gearing was just about Fixed costs : Variable cost and the impact of having high FC.
If we are asked to comment on the op.gearing of a company and touched purely on the impact of high FC vs VC. Are we doing the right thing?Thank you very much
There are, as you point out, several ways of calculating operational gearing. Examiners will not care which method you use. Personally, I like to use:
FC/VC
or
FC/(FC + VC)
These equations are analogous to the calculation of financial gearing and seem to me easy to interpret. If FC>>>VC you will be in real trouble if volumes fall as costs do not fall much, just a with high financial gearing you will be in trouble if volumes fall because interest is a fixed cost.
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