Question 7.RQ.3: When we say that some business activity has high operating g...
When we say that some business activity has high operating gearing, what do we mean? What are the implications for the business of high operating gearing?
Operating gearing refers to the extent of fixed cost relative to variable cost in the total cost of some activity. Where the fixed cost forms a relatively high proportion of the total (at the business’s normal level of activity), we say that the activity has high operating gearing.
Typically, high operating gearing is present where there is a relatively high level of mechanisation (that is, capital- intensive environments). This is because such environments tend simultaneously to involve relatively high fixed cost of depreciation, maintenance and so on and relatively low variable cost.
High operating gearing means that the effects of increases or decreases in the level of activity have an accentuated effect on operating profit. For example, a 20 per cent decrease in output of a particular service will lead to a greater than 20 per cent decrease in operating profit, assuming no cost or price changes.