Rethinking Cost Structures: What’s Wrong With Fixed/Variable Costs
Summary: The traditional fixed and variable cost framework breaks down in our fast-paced business world, as it fails to capture the dynamic nature of modern business operations. In reality, costs are never truly fixed or variable, but it depends on the timeframe in consideration when looking at them. Alternative methods that adopt a dynamic perspective allow businesses to better adapt to market volatility. Strategies like short-term contracts, activity-based costing, marginal costing, and lean accounting provide practical steps towards a resilient business model. The goal is to empower businesses to make informed decisions about pricing, production, and profitability in today’s rapidly changing market environment.
In this article, I will explore the limitations of the conventional way to analyze cost structures: the fixed and variable model, and discuss alternative approaches to understanding cost structures.
I will show that the fixed and variable cost model is an oversimplification of the cost structure of a business and that it can lead to incorrect assumptions and decisions.
Crucially, a fundamental flaw in the fixed and variable cost model is that it doesn’t take into account the time context of business operations.
Costs are much more dynamic than the categorization into two distinct buckets — fixed or variable. This oversimplification doesn’t acknowledge that the behavior of costs can shift over different periods.
For instance, what may be considered a fixed cost in the short term may become a variable cost over a longer timeframe, and vice versa.
The key takeaway is: costs are never truly fixed or variable. It depends on the timeframe in consideration when looking at them.
In the forthcoming sections, I will delve deeper into this issue and explore more nuanced cost structures that take time horizons into account, offering a more comprehensive and accurate view of business costs.
What are Fixed and Variable Costs?
Before discussing the limitations of fixed and variable costs, I will first define what they are.
Fixed costs are costs that do not change with changes in output or sales.
Examples of fixed costs include rent, salaries, and equipment depreciation. These costs are usually paid on a regular basis, regardless of how much a business sells or produces.
Variable costs, on the other hand, are costs that do change with changes in output or sales.
Examples of variable costs include the cost of raw materials, labor costs, and shipping costs. As a business sells more products or services, its variable costs will increase.
The fixed and variable cost model is often used in financial analysis and budgeting because it can help businesses understand how their costs will change with changes in sales or production.
For example, if a business knows its fixed costs, it can calculate its breakeven point — the point at which it is selling enough to cover its fixed costs and start making a profit.
The Limitations of Fixed and Variable Costs
The fixed and variable cost model fails to account for the dynamic nature of business operations.
Most costs change depending on time-frame, so they cannot be categorized as either fixed or variable; the model fails to portray the dynamic nature of business reality. This section explores some more specific limitations which spring from failing to consider the dynamic nature of business costs.
1. Semi-Variable Costs
One limitation of the fixed and variable cost model is that it does not account for semi-variable costs.
Semi-variable costs are costs that have both a fixed and variable component.
For example, the cost of leasing a machine may have a fixed monthly payment, but it may also have a variable component based on how much the machine is used.
Semi-variable costs can be tricky to account for because they have characteristics of both fixed and variable costs.
If a business assumes that all of its costs are either fixed or variable, it may misinterpret the cost structure and make incorrect assumptions about breakeven points and profitability.
2. Time Horizons
Another limitation of the fixed and variable cost model is that it can vary depending on the time horizon being considered.
In the short term, some costs may be considered fixed, but in the long term, they may become variable.
For example, consider a business that rents a commercial space for its operations. The rental expense, under a signed lease agreement, is a fixed cost in the short term because it doesn’t change regardless of the level of output. However, over the long term, if the business decides not to renew its lease, this cost becomes variable. The company may choose to move to a different location, downsize, or even shift to a remote work model, thus changing what was initially considered a fixed cost.
The time horizon is important to consider because it can affect how a business should plan for its costs.
If a business assumes that its costs will remain fixed in the long term, it may fail to prepare for changes in the cost structure and end up in a difficult financial position.
3. Direct and Indirect Costs
The fixed and variable cost model can sometimes oversimplify the complex nature of business costs, especially when it comes to distinguishing between direct and indirect costs.
Direct costs are costs that can be directly attributed to a product or service, while indirect costs are costs that cannot be directly attributed to a product or service. Examples of direct costs include the cost of raw materials and direct labor costs, while examples of indirect costs include rent and utilities.
Both direct and indirect costs can be fixed or variable. However, businesses sometimes fail to properly account for and allocate these costs.
Indirect costs, in particular, can comprise a significant portion of the total costs. Neglecting them can lead to misjudgments about profitability and break-even points.
It’s crucial, therefore, for businesses to consider both direct and indirect costs in their cost structure analysis, and not oversimplify by merely categorizing costs as fixed or variable.
4. Inaccuracy of Assumptions
The fixed and variable cost model assumes that costs are fixed or variable based on their behavior, which may not always be accurate.
For example, a business may have a fixed cost that is only fixed within a certain range of output or sales. Once the output or sales exceed a certain level, the cost may become variable.
Assuming that all fixed costs are truly fixed and all variable costs are truly variable can lead to inaccurate assumptions about the cost structure and profitability of a business.
So, the fixed/variable model is context-, scale-, and time-relative, turning the model into a weak framework to assess business performance, especially in dynamic businesses or startups.
In essence, overlooking the time context of business operations is perhaps the most pervasive and consequential error in the fixed and variable cost model.
Time, as a key factor, influences the dynamic nature of costs, affecting their behavior in ways that are often overlooked in traditional cost analysis.
While the model may serve as a decent starting point for understanding costs, its inability to adapt to different time horizons often leads to oversimplification and a lack of foresight. Over the short term, certain costs may appear fixed, but given enough time and changing business conditions, these costs may reveal their variable nature. Likewise, what are perceived as variable costs may become more fixed over a longer horizon due to scale efficiencies or contract agreements.
Embracing a more dynamic and time-sensitive approach to cost analysis can offer a more robust and accurate perspective, enabling businesses to plan and strategize more effectively.
Case Scenario: How The Fixed/Variable Model Can Affect Your Business
Consider a hypothetical tech startup, “TechX”, which provides an online platform for freelance graphic designers.
TechX’s fixed costs are its lease on office space, salaries for its permanent employees (engineers, support staff, and management), and subscriptions for various software tools. The variable costs are server costs, which increase as more freelancers and clients join the platform, and the customer support team’s expenses, which are directly tied to the number of platform users.
Using the fixed/variable cost model, the startup calculates its breakeven point (the point at which total revenue equals total costs incurred, so there’s neither profit nor loss), and sets its pricing and growth strategy.
It estimates that by adding a certain number of freelancers and clients to the platform each month, it can cover its fixed costs and start making a profit within a year.
However, after some months, TechX notices its actual profits are significantly below its projections. It soon discovers that its cost model was overly simplistic and overlooked key aspects:
- Semi-variable costs: TechX failed to account for semi-variable costs, such as electricity and internet. These costs remained fixed up to a certain point but increased significantly as the company grew, and more employees and servers were added.
- Economies of scale: TechX failed to consider that some of its variable costs, such as server costs, could decrease per unit as its user base grew, due to economies of scale.
- Indirect costs: TechX did not adequately account for the increase in indirect costs such as administrative costs and equipment depreciation as the company grew.
By relying solely on the fixed/variable cost model, TechX’s projections were off, and its pricing strategy didn’t cover all the actual costs.
This hypothetical scenario illustrates how an oversimplified view of costs can potentially lead to detrimental financial decisions, highlighting the importance of having a more nuanced understanding of cost behavior.
Alternative Approaches to Understanding Cost Structures
Given the limitations of the fixed/variable cost model, it’s important for businesses to consider alternative models through which to understand their cost structures. This will bring to the fore other crucial features of your business model. Some of these include:
1. Activity-Based Costing
Activity-based costing is an approach that assigns costs to specific activities or processes rather than to products or services.
This approach can be useful for businesses that have complex cost structures with many indirect costs. By assigning costs to specific activities, businesses can more accurately understand the cost of producing a product or providing a service.
Let’s say a company produces two types of chairs: a basic wooden chair and a high-end leather chair. The company uses the same production line to manufacture both chairs, but the leather chairs require additional steps and materials, such as cutting and stitching the leather and adding foam padding.
To determine the cost of each chair using activity-based costing, the company would first identify all the activities involved in producing both types of chairs, such as cutting wood, cutting leather, stitching leather, assembling, etc.
Next, the company would determine the cost of each activity, including direct costs (such as materials and labor) and indirect costs (such as rent and utilities). For example, the cost of cutting wood might include the cost of the wood itself, the cost of the saw blades, and the cost of the employee’s time, while the indirect costs might include the cost of maintaining the saws and the cost of heating and lighting the workshop.
Once the company has determined the cost of each activity, it can allocate those costs to the chairs based on the amount of each activity used. For example, if the leather chairs require twice as much cutting and stitching as the wooden chairs, they would be assigned a higher portion of those costs.
By using activity-based costing, the company can more accurately determine the cost of each chair and make more informed decisions about pricing, production, and profitability.
2. Marginal Costing
Marginal costing is an approach that focuses on the costs of producing one additional unit of a product or service.
This approach can be useful for businesses that are trying to make decisions about pricing or production levels. By understanding the marginal cost of producing an additional unit, businesses can make more informed decisions about whether to produce more or fewer units.
Marginal costing is more advantageous than the fixed/variable cost approach because it can help you maximize profits. A company will produce to the point where marginal costs equals marginal revenue (i.e., the costs of producing 1 more unit amounts to the marginal revenue it’d generate), beyond that point the cost of producing an extra unit will exceed the revenue generated.
Consider the warehouse for a manufacturer of landscaping equipment. The warehouse has capacity to store 100 extra-large riding lawn mowers. The margin cost to manufacture the 98th, 99th, or 100th riding lawnmower may not vary too widely.
However, manufacturing the 101st lawnmower means the company has exceeded the relevant range of its existing storage capabilities. That 101st lawnmower will require an investment in new storage space, a marginal cost not incurred by any of the other recently manufactured goods.
Instead of thinking of costs as either fixed or variable, marginal costing introduces a perspective in which you focus on the differences that make a difference.
Sometimes, producing 10 units more doesn’t change your costs very much, but other times, it requires an entire new machinery which involves significant costs. Thus, using the metric of marginal costing is better to decide how much you want to produce.
You should aim to maximize production within your chosen relevant range.
If you are looking to scale, make sure to take full advantage of your new acquired productive capacity.
Within your chosen relevant range, aim at producing n-1 units, where n would be the amount of goods produced / services delivered that would require a significant investment into readjusting your production machinery/strategy.
In other words, marginal costs help determine the most efficient level of production for a manufacturing process.
3. Lean Accounting
Lean accounting is an approach that focuses on the elimination of waste and the creation of value.
This approach can be useful for businesses that are trying to reduce their costs and improve their profitability. By focusing on value creation, businesses can identify areas where they can reduce costs without sacrificing quality or customer satisfaction.
Having a customer-centric approach to your cost structures can prove beneficial to your company.
A lot of non-quantifiable benefits emerge from providing quality experience to your users, such as brand loyalty (users keep coming back) or organic marketing through word of mouth.
Lean accounting is a method that strives for a holistic business approach which, ironically, by not being solely based on cost-effectiveness, becomes a lot better at maximizing profit.
While the fixed and variable cost model might have been a useful way to understand the cost structure of a business, the constantly evolving market reality that we are experiencing today demands businesses acquire dynamism and resilience.
These provide the ability to adapt to a rapidly changing environment. To better assess a dynamic business, the fixed and variable cost model should be replaced by other metrics which are better suited to management today.
Businesses would benefit from becoming aware of the fixed/variable model limitations and consider alternative approaches to understanding their cost structures.
Acquiring an awareness of how many more costs are variable in the right framework, or from the adequate point of view, enables a more dynamic business model. Rather than classifying some costs as fixed and others as variable, realizing that your business can be flexible on the durability and quantity of costs allows for better adaptability.
For example, rather than hiring someone for a long period of time (long-term contracts are often seen as favorable), it might be worth having short-term contracts to assess employee standards and decide if they are suited to the requirements and environment of your business.
By using alternative approaches, such as activity-based costing, marginal costing, and lean accounting, businesses can gain a more accurate understanding of their costs and make more informed decisions about pricing, production, and profitability.
Developing a business strategy is a key part of any enterprise or long-term firm management, and having nuanced metrics at hand will ensure your strategy is carried out in the most efficient and effective way possible.