How to Calculate Operating Gearing

Operating Gearing (Leverage) Calculator

Calculation Results

Contribution:

Operating Profit (EBIT):

Degree of Operating Gearing (DOL):

function calculateOperatingGearing() { var revenue = parseFloat(document.getElementById('totalRevenue').value); var variableCosts = parseFloat(document.getElementById('variableCosts').value); var fixedCosts = parseFloat(document.getElementById('fixedCosts').value); var resultDiv = document.getElementById('gearingResult'); if (isNaN(revenue) || isNaN(variableCosts) || isNaN(fixedCosts)) { alert("Please enter valid numbers for all fields."); return; } var contribution = revenue – variableCosts; var profit = contribution – fixedCosts; if (profit 3) { interpretationText = "High Operating Gearing: A small percentage increase in sales will result in a significantly larger percentage increase in operating profit. However, it also indicates higher risk if sales decline."; } else if (dol > 1.5) { interpretationText = "Moderate Operating Gearing: The business has a balanced mix of fixed and variable costs."; } else { interpretationText = "Low Operating Gearing: Most costs are variable. Profits are stable but won't grow exponentially with sales increases."; } document.getElementById('interpretation').innerText = interpretationText; resultDiv.style.display = "block"; }

---

Understanding Operating Gearing (Operating Leverage)

Operating gearing, also known as the Degree of Operating Leverage (DOL), is a financial ratio that measures how sensitive a company's operating income is to its sales volume. It essentially looks at the proportion of fixed costs versus variable costs in a company's cost structure.

The Formula for Operating Gearing

There are two primary ways to calculate operating gearing. The most common formula used for a specific level of sales is:

Operating Gearing = Contribution / Operating Profit

Where:

• Contribution = Total Revenue – Total Variable Costs
• Operating Profit = Contribution – Total Fixed Costs

Practical Example

Imagine a software company (Company A) and a consulting firm (Company B) both earn $1,000,000 in revenue.

• Company A (High Gearing): Has high fixed costs (server maintenance, R&D) of $600,000 but low variable costs of $100,000.
  Contribution: $900,000 | Profit: $300,000 | DOL: 3.0
• Company B (Low Gearing): Has low fixed costs (small office) of $100,000 but high variable costs (freelance consultants) of $600,000.
  Contribution: $400,000 | Profit: $300,000 | DOL: 1.33

If sales increase by 10%, Company A's profit will increase by 30% (10% x 3.0), while Company B's profit will only increase by 13.3% (10% x 1.33).

Why Operating Gearing Matters

Operating gearing is a double-edged sword. It acts as an amplifier for a business's bottom line:

1. Upside Potential: High gearing is excellent during periods of sales growth. Once fixed costs are covered, a large portion of every additional dollar in sales drops straight to the bottom line.
2. Downside Risk: During an economic downturn, high gearing is dangerous. If sales drop, fixed costs remain constant, which can quickly lead to operating losses.
3. Business Strategy: Capital-intensive industries (like airlines or manufacturing) naturally have high operating gearing. Service-based industries usually have lower gearing.

How to Use This Calculator

To use the calculator above, simply input your financial figures from your Income Statement (P&L):

• Total Revenue: Your top-line sales.
• Variable Costs: Costs that change directly with sales (e.g., raw materials, shipping, sales commissions).
• Fixed Costs: Costs that stay the same regardless of sales (e.g., rent, salaries, insurance).