Cost Structure (Operational Gearing)

The proportion of fixed costs in the operational cost structure of a company will have a significant effect on the volatility of its profits to changes in demand for its products. A company with a large proportion of fixed costs (e.g. a manufacturing company) will have a smaller margin of safety than a company with a small proportion of fixed costs (e.g. a service company). However, with most costs unaffected by volume in the short term, an unexpected upturn in trading activity would bring a sharp increase in profits. The amount of fixed costs in the cost structure is termed operational gearing and has an effect similar to capital (financial) gearing (see weeks 5-6) which concerns the effect of fixed interest payments.

Example: Company A and company B both sell their product at £3 per unit, both sell 300 units, both have the same total costs of £600 at this volume, so both make £300 profit.