Fixed costs are everywhere
What do airplanes, hospital equipment, and full-time employees have in common? They are all fixed costs. These are costs that a business incurs, regardless of how many passengers you carry, patients you treat, or products you sell.
Buildings, equipment, airplanes
Perhaps the easiest example are big, physical, expensive things:
- Sports stadium = expensive. Expensive regardless of the number of sports games played and tickets sold
- Medical equipment = expensive. The MRI probably costs $3M regardless of the number of scans performed
- Airplane = expensive. Expensive whether it sits on the ground being maintained, or flying in the air
Ask ChatGPT for a list of fixed costs in your industry, and you’ll get the point.
Empty houses = no good
You rent an apartment with a year lease. You go on vacation in Scotland for 3 weeks (good for you). When you come back, does the landlord give you a refund of 3 weeks rent? Doubt it.
Whether you got full value out of the apartment is not her problem. The same is true of gym membership or car you don’t drive. A house full of unused stuff is not great. Think: empty vacation home = waste of money.
Asset utilization: Use it or Lose it
If you have something valuable, use it.
So What?
There are a lot of implications here:
- Going asset-lite is awesome, why take on fixed-costs if you don’t have to?
- If you have a lot of fixed-costs, you need to run the factory full; get the most out of the assets you have
- If you competitor has a lot of fixed costs, watch out. . . because they are only trying to cover their marginal costs
- Fixed costs = inflexibility; it creates barriers to exit, you are getting handcuffed into the business
- Utilization matters; yes of people
1) Asset lite is awesome
This is one of the biggest changes over the last 30 years. It’s incredibly easy to start up a business because the amount of fixed cost investment is low. You can work remotely (no office), you can use free software (Slack, Google Docs), you can build a website for $100 (Wix, WordPress), you can outsource design (99designs), you can outsource manufacturing (Alibaba), you can drop/ship directly to the customers (Amazon), and get payments (Shopify).
When I graduated from college (warning: old person talking); companies had email servers on-prem. Cray.
2) “Run the factory full”
If you were the VP of a factory, you want to keep it running smoothly. More production makes you happy. More production = easier planning, easier staffing, and less variability. More production makes us more profitable %.
lower fixed cost / unit
Simple math. You have a fixed cost of $5K for a piece of t-shirt printing equipment that lasts 1 year. Whether you make 1,000 t-shirts or 75,000 t-shirts, you’re not getting the $5K back. No refunds.
So, it makes sense to produce more stuff. . . because the same $5K gets divided into more units. Will the cost of your machine be divided by 1,000 t-shirts or 50,000 of them? If you have to pay for the factory anyways, you might has run full production and distribute the fixed cost into 50,000 units. Fixed costs per unit (if 50K) is 10cents.
Economies of scale
Executives love this phrase. Get bigger so you can spread your fixed costs over more units. Getting bigger can lower your relative cost structure. You see this driving a lot of M&A over the last 30 years.
3) MR = MC
In the short-run, you should produce more product until your marginal revenue = marginal cost. This is wonky “oh economics is so boring” thing to say, but as long as you are covering your marginal costs, keep going.
- I am an oil producer. I spent a lot of $$$,$$$,$$$ on oil fields, equipment, distribution, and technology. However, it only costs be $$ per barrel to pull it out of the ground. Well, in the short-term, as long as I can sell it for $$ + 1 dollar, it’s worth doing. Basically, your fixed costs are sunk and shouldn’t factor into your “pump or not pump” decisions.
- I run an movie theater; getting the licensing rights for the movie is expensive. The building is expensive. The additional (marginal) cost of the air conditioning and the popcorn is small. Therefore, it make sense for me to stay open even during weekday mornings, when there are only a half dozen people in the theater
- I am a teacher; if I still have 10 seats left in my class by the time the semester starts, it would be advantageous to sell those seats for cheap, because the marginal cost of have 10 extra students is a) teacher’s time to grade papers, b) print out extra hand-outs c) extra office hours?
4) Fixed costs = Exit costs
All fixed cost are not sunk. Namely, if you have a long-term lease on a building, or have debt payments, even if you stop production (stop pumping oil out of the ground, stop showing movies, or stop teaching), you still need to pay your debts.
So, these can be impediments to exiting the business.
- “Well, we’re not making a lot of money at the shop, but the contract runs for another 3 years, so we need to keep the lights on until then. Then we will stop and retire.”
- “What’s the potential impact to our brand and customer promises, if we exit this part of the business?”
5) utilization matters
Any consultant is aware of the word, “utilization”. For those not professional services, this may seem slightly robotic. After all, why are we trying to “use” people. However, for me, of course this makes sense.
Companies and employees can all agree that “human capital is the biggest asset”. The best firms are not just technology, balance sheets, and brands. In professional services firms, this can be up to 80% of the total costs. What is a consulting firm, but a bunch of smart people, history, relationships, culture, and process?
- I run a roofing business, I have 25 employees. Of course, I want them to be busy
- I run a restaurant, of course I want to have as few cooks and servers are needed, to do a great job for diners
- I run a school, of course I want as few faculty members and staff as possible to do a great job for students
Lots of idle people = wasted talent and budget. People are an economic asset (fact).
Individuals want to create value (Work)
Any new hire wants to quickly show their value. “You hired the right person”. Go-getters want to get stuff done. The company, recruiters, MD also want to see the benefits of their recruiting efforts. Recruiting is enormous work. Match-making companies and people is difficult; that’s also why an enormous, valuable business.
As consultants, the beautiful simplicity of billable work:
Win #1: It’s a simple way to track the profitability of time; I have 2,000 (or 1,760) hours in a year. This is my utilization. Either I brought in $$$,$$$ for myself or that much for my firm (when then pays me).
Win #2: Client work = real work. It’s not theoretical. As a professional, you are hired to do great work. Your work will then impact lives, budgets, and careers of clients. All meaningful, it matters.
Win #3: People want to add value. Go-getters know the bigger impact = bigger praise = bigger money. Thinking like a Premiere league announcer, “finish” the goal. Put laces through the ball.
Win #4: After years of training (MD, DO, RN, MBA, PhD, CPA, CFA, CFP); let’s test all the theory in the real world.
Win #5: Networks matter. New people and the experienced people collaborate intensely on projects. Clear start, middle, end. Teams bond as they win in the market, win with clients, win with their careers. This is how you build a network.
Companies want to create value (Work)
Companies need to win in the market, make money, make payroll. It’s the role of managers and companies to get the most out of their people; through vision, direction, staffing, training, encouragement, incentives, OKR, organizational design, culture, teaming, hook or crook. How about these deep, almost indicting statements from Drucker?
“The productivity of work is not the responsibility of the worker but of the manager.” – Peter Drucker
“As a manager, you’re paid to be uncomfortable. If you are comfortable, it’s a sure sign you’re doing things wrong” – Peter Drucker
Companies want leaders
It’s difficult to make money. Competition exist. Technology is creative destruction (think: Schumpeter). It’s never been easier to start a business, but staying profitable over 10+ years is difficult.
Leadership is crazy important for a reason. Choose any great company, and trust me, they would be not be great without brave leaders, competent decision makers, and thoughtful risk-taker. Once again, this is not hyperbole; this is a fact.
Leaders are so hard to find that founders “keep coming back” to their companies. That’s why CEO get recruited from one place to another. They are VRIO. Valuable, rare, hard to imitate, and they own all the good decision-making stuff.
Yes, people are assets (compliment)
You and I are all valuable assets. Assets to ourselves, our families, our friends, our nation.
We are TOO GOOD and too expensive to put to waste by being idle. Let’s do the work. Let’s go.