What does operational gearing measure?

Operational gearing measures the relationship between fixed costs and variable costs within a business's cost structure. It is an important concept in financial management as it indicates how changes in sales volume will affect the profitability of the business. A higher ratio of fixed costs to variable costs suggests that a company has a higher level of operational gearing, meaning that small changes in sales can lead to larger changes in profits. This is because fixed costs remain constant regardless of the sales volume, which means that as sales increase, the fixed costs are spread over more units, enhancing profitability. Conversely, if sales decline, the fixed costs still need to be covered, which can significantly impact net income negatively. Understanding operational gearing is crucial for businesses in planning and strategy, especially in assessing risk and making decisions about scaling operations.