ACCA Financial Management (F9) Certification Practice Exam

What does Operational Gearing refer to?

1. Profit before interest and tax / Total assets

2. Contribution / Profit before interest and tax

3. Current liabilities / Total debts

4. Debt / Equity ratio

The correct answer is: Contribution / Profit before interest and tax

Operational Gearing, also known as operating leverage, refers to the ratio of contribution (sales revenue minus variable costs) to the profit before interest and tax (also known as EBIT). This concept highlights the proportion of fixed costs in a company’s cost structure. Firms with high operational gearing have a higher proportion of fixed costs relative to variable costs, which means that a change in sales can lead to a more significant impact on profitability. When sales increase, the contribution rises but the fixed costs remain unchanged, leading to a proportionally larger increase in profit before interest and tax. Conversely, a decline in sales can lead to a more substantial decrease in profits due to the burden of fixed costs. Understanding operational gearing is essential for assessing the risk and volatility of a company's earnings in relation to its sales fluctuations.