Question

In your own words, explain operating gearing and its relationship to contribution.

Answer 1

Operational gearing (also termed to be the operating leverage) tells the relationship among the company's fixed costs (costs which remains fixed regardless of how many sales the company makes) and variable costs (costs that changes along with the level of turnover). The degree of operating gearing is computed as contribution margin divided with the operating income where the contribution margin is computed as the differential amount between the sales revenue and total variable costs. The high operational gearing indicates that the firm's fixed costs are high as a proportion of total costs; and it will be risky because indicates that although the variable cost declines when revenue falls but fixed costs remains constant.