ACCA Financial Management (F9) Certification Practice Exam

What does operational gearing measure in a business?

1. The amount of fixed costs in relation to variable costs

2. The level of debt relative to total assets

3. The profitability of investments

4. The ratio of equity to liabilities

The correct answer is: The amount of fixed costs in relation to variable costs

Operational gearing, also known as operating leverage, specifically measures the relationship between fixed costs and variable costs in a business. It indicates how the level of fixed costs, which do not change with the level of production, affects the overall profitability of the company as sales increase or decrease. A business with high operational gearing has a larger proportion of fixed costs in its cost structure compared to variable costs. This means that small changes in sales volume can result in significant changes in operating income or loss, amplifying the business's financial performance. For instance, if the sales increase in a company with high operational gearing, the impact on profits is greater due to the relative stability of fixed costs. Conversely, in a scenario where sales decline, the same high fixed costs can lead to substantial losses. Understanding operational gearing helps business managers make decisions related to pricing, production levels, and financial strategy.