Your REAL Fixed Costs are
If you want to improve the economic performance of your business, it is essential to first understand the behavior of your costs. Most businesses spend considerable resources measuring their costs, and can readily present many aspects of their costs in great detail, including, for example, standard product costs and variances, costs by business unit, costs by product line, costs segregated by materials and labor, and so forth.
However, while it is a simple concept and one that is used every day, many businesses have surprisingly little grasp on how many of their costs are fixed and how many are variable. Ironically, in spite of the fact that collecting and analyzing financial information is the sole purpose for its existence, this simple question is one that your accounting organization is most likely poorly equipped to answer.
Here's a technique that you can use to determine and, even more importantly, understand the behavior of your costs. But first we need a brief refresher course and a better understanding of why it is important to understand your fixed and variable cost structure.
Fixed and Variable Costs
Costs are typically categorized as either fixed or variable. Fixed costs, by definition, are costs that do not vary as your sales volume increases or decreases, while variable costs increase linearly as sales go up or down. Some examples that are often given for fixed costs include depreciation, debt service, insurance, and many general and administrative costs. Some examples of variable costs that are often quoted are cost of goods sold, sales commissions, shipping charges, delivery charges, costs of direct materials or supplies and direct labor.
In practice, most "fixed costs" are actually semi-fixed -- that is they tend to go up and down in steps as, for example, when a new factory is added. By the same token, many variable costs are, in reality, semi-variable. However, for our purposes, and within a reasonable range of sales, we can treat fixed costs as truly fixed, and variable costs as varying smoothly with sales.
In part because most costs are actually semi-fixed and/or semi-variable, in practice, classifying costs into either one bucket or the other is fraught with difficulty. Intelligent and otherwise rational people can argue for hours about whether a cost item is fixed or variable. What usually happens is that costs are classified as fixed only if they are fixed under the majority of circumstances. This tends to lead to a conservative (low) estimate of fixed costs, and a liberal (high) estimate of variable costs.
Assuming one is at least reasonably successful in classifying costs into fixed and variable (or at least believes that they are successful), these fixed costs, variable costs, and sales levels can be related graphically on the classic breakeven graph.
Units of production are typically arrayed along the Y-Axis, and Dollars along the X-Axis. Since costs (hopefully) rise more slowly than revenues, above a certain sales level the company generates a profit, whereas below this "breakeven point" the company loses money.
Note that the company's fixed costs are, by definition, its total costs if its sales level were zero. This observation provides a handy way of determining what the fixed costs of a business actually are -- without resorting to any arbitrary definitions of what are or are not fixed costs.
How You Can Easily Determine Your Fixed Costs
Here's a technique that you can apply using breakeven analysis to determine your actual fixed and variable costs. However, before we start, write down your estimate of the fixed costs for your company. I think you will find that your estimate is alarmingly low.
First get your monthly or, if necessary, quarterly financial results for the last few years - usually 2 to 4 years is good. Using Microsoft Excel or Lotus 1-2-3, depending on your preference, you will develop a graph of this data.
Create two columns on your spreadsheet. Label the first column "Sales" or "Revenues", and the second column "Costs". In the first column put the sales or revenues from your first period results, and in the second column put the costs from that same period. In the "Costs" column you can put either Cost of Goods Sold, Total Operating Costs, or even just Sales, General, and Administrative Costs. Obviously, the graph will tell you very different things depending on which you choose. In fact, you will probably want to do all three to understand how your costs behave in both production and non-production functions.
Now create the graph. Choose "X Y (Scatter)" as the Chart Type. You will create two lines (or "Series" of data in either Excel or 1-2-3). The first line (Series), which you should label "Sales" or "Revenues", will have your sales/revenues values in the first column for both the "X" values and the "Y" values. When you plot these points, they will fall in a straight line and, if you have adjusted the scales on your chart so that the X-axis and the Y-axis are the same, they will fall along a 45 degree angle. So far not very exciting, but bear with me.
The second line, which you should label "Costs", will use your sales/revenues values from the first column for the X-axis values, and your costs values from the second column for your Y-axis values. These points will typically not form a straight line, but if all goes well, they should tend to trend in the same general direction. Make sure that the scale on both the X and Y axes are set so they go all the way down to zero. So far, you should have something that looks more or less like this:
Now it starts to get interesting. Next, you're going to add trend lines through both sets of data points. Depending on whether you are using Excel or 1-2-3, the procedure will be a little different. On Excel, under the "Chart" drop-down menu, you will choose "Add Trendline", and choose "Linear" for the "Trend/Regression Type". Also, for the data points representing only your cost data, under the "Options" tab, check the check boxes for "Display Equations on Chart" and "Display R-Squared Value on Chart".
On 1-2-3, you will click on the data points on your chart, and in the "Properties" box choose the "Series Trend" tab. Again, choose "Linear" for "Type". You will do this for both sets of data points. For the data points representing your cost data, beneath where you selected "Linear", make note of the values that Lotus provides for "R-Squared", "Slope (B)", and "Y-Intercept (A)". You should have something that looks like this:
Understanding What It Means
Now let's see what we have. When you were selecting "Linear", you were creating a best-fit line through the data points. Obviously, the best-fit line through your revenue line isn't very interesting, because it is merely sales plotted against sales (always a straight line, and always a perfect fit). However, there is a lot of information in the line through your cost data.
The R2 on your chart is a measure of how well the trend line reflects the actual data. R2 can vary between 0, representing no correlation, and 1.0, representing perfect correlation. If you were to check the R2 on your revenue data, you would notice that it was 1.0. An R2 over 0.9 is quite good and, while the R2 in our example is only 0.7171, it still seems to be an acceptable correlation.
Now the equation. If you remember your grade school math, this is the equation for a straight line of the form y = ax + b. The "a" represents the slope of the line, and the "b" represents the Y-intercept - the place where the line crosses the Y Axis. Remember, that we were looking for fixed costs, and this Y-intercept "b" is, in fact, your fixed costs - the amount that your costs would be if your sales level were zero. In this particular case, the company needs to have sales of $726,250 per month just to cover its fixed costs. The slope of the line, "a" in the equation, tells you your variable costs. In this case, the company's costs go up only $0.338 per dollar of sales.
Finally, let's bring the revenues line into the picture. The point at which the revenue and the cost lines cross is your breakeven volume. This is the sales volume at which your revenues will exactly equal your costs. If you were plotting total costs, this is very helpful to know. Obviously, if you were plotting only CoGS or SG&A expenses, this "breakeven point" has little meaning.
Doing Something About It
It is essential to understand your cost structure - that is, how much of your costs are fixed, and how much are truly variable - because it suggests very different treatments. Variable costs tend to "take care of themselves" because they drop when sales levels drop. Further, while controlling variable costs is important, in the preceding example focusing on reducing fixed costs would be likely to have more impact than focusing on variable costs.
Notice also that your company's cost structure has an influence on your competitive response, particularly in a market downturn. High fixed costs tend to limit the options available to you in a manner similar to high levels of debt. In fact, high fixed costs are sometimes referred to as high operating leverage. The company with high levels of fixed costs will have an imperative to maximize sales volume, even if it comes at the expense of marginal profit. In a soft market, the need to maintain volume is likely to require price reductions and a destructive war for market share.
Further, note that financial leverage and operating leverage can be additive. The company that has high levels of debt is living dangerously if it also has a cost structure that is weighted toward costs that act fixed (regardless of whether the company thinks they are fixed or not).
If you are like most organizations, your company's true fixed costs are probably higher than your original estimate - perhaps a lot higher. As I observed earlier, this is because in a black-or-white world, semi-fixed and/or semi-variable costs usually get thrown into the variable category rather than the fixed. In particular, companies often tend to think of labor costs as variable, in the belief that they can readily downsize if the market softens.
Unfortunately, in practice, this is seldom true.Those costs that increased as sales levels increased tend to get "embedded" so they don't decrease when sales levels fall. Rather, what tends to happen is that when sales volume declines, the workload on each individual goes down a little so that everyone is working at less than full capacity. When you go to look for the "excess" personnel, they just aren't there. The only option is an arbitrary across the board cut, with the hopes that the people on the front lines will be able to shift bodies around to make things work. The outcome is often even weaker performance.
So what do you do? If you want to attack your fixed costs, the only way to go about it is an organized process analysis and redesign effort. Attacking fixed costs requires that you fundamentally rethink how you are defining jobs and how you are performing the tasks that comprise your business.
Rolf Grun is the president of Competitive Logic, LLC (www.CompetitiveLogic.com), an Atlanta-based general management consulting firm. Competitive Logic works with small and medium-sized clients in business-to-business markets to help them develop strategies that will maximize their economic and competitive potential, and redesign their operations to take advantage of these opportunities. Mr. Grun has more than 21 years of professional experience, including 13 years of experience with PricewaterhouseCoopers and 6 years of experience with Texaco. Mr. Grun holds BS degrees in Mechanical Engineering and Geology, both with honors and both from Tufts University, and an MBA from the Harvard Business School. You can reach Rolf at RGrun@CompetitiveLogic.com .
Many more articles in The CFO Refresher in The CEO Refresher Archives