- Andrew DeMaio
- February 17, 2016
If you ever took an accounting course, you probably didn’t escape the first week of class without being introduced to the concept of fixed and variable costs. Fixed costs don’t change as demand goes up and down; variable costs do. Economies of scale are achieved because of fixed costs. Variable costs reduce the impact of fluctuations in production or consumption. Neither is inherently “good” or “bad.” You’d be hard-pressed to find any enterprise whose cost structure is 100% variable or 100% fixed.
Identifying and classifying costs as fixed or variable takes time and effort, including a review of GL entries and the Chart of Accounts to determine if the associated costs are actually fixed or variable or a bit of both. Is it worth the effort? To answer that, let’s look at some of the management questions whose answers depend on knowing your fixed and variable costs:
What Spending Can I Impact?
Two common TBM goals are cost reduction and cost avoidance. Cost reduction tends to focus on variable costs. Why? Fixed costs are often hard to adjust in the short term. Some are non-cash expenses like depreciation that will hit the P&L no matter what; others like fixed length contracts or rent will be recurring unless there are termination provisions included. In a cost reduction scenario – where the focus is often on immediate changes and instant gratification – fixed costs will not help the cause.
Which leads us to variable costs. If you can identify your total variable costs you can look for opportunities for cost reduction. Or, conversely, if you can’t identify your variable costs the process of identifying cost reduction opportunities becomes much harder.
Cost avoidance, on the other hand, is all about making better use of the resources you already have. Optimizing infrastructure, rationalizing your app portfolio, and adjusting your labor strategy are all activities that improve how you use what you are already paying or paid for. By avoiding, for example, additional hardware and software purchases you are also preventing additional future fixed costs from hitting your P&L. If you have budgeted your fixed costs correctly you’ll be able to see how they will change in the near future and understand their impact on your total costs.
Identifying the opportunities and impact of cost reduction or cost avoidance activities depends on first classifying those costs as fixed or variable.
How Agile Am I?
“Agility” is a popular concept for IT organizations. The ability to shift priorities and react to change may be the difference between success and failure, or between market leadership and being an “also-ran.” One way of potentially increasing agility is to shift an organization’s cost structure toward more variable costs. It may be easier to repurpose IT spend dollars if those dollars are currently spent on variable cost items.
here is much more to agility than variable cost, however. Technology choices can potentially have a much larger impact on agility than cost structure (e.g., providing a virtualization environment that is flexible enough to handle a wide variety of workloads). But technology options like Public Cloud where you can pay based on consumption (i.e., variable) can increase agility by reducing the need for investment in in-house capacity which adds additional future fixed cost to your P&L.
But nothing is ever completely free. Since, as mentioned above, fixed costs don’t vary as consumption changes, the average unit cost to deliver a service goes down as volume goes up. Which means that there is often a trade-off between cost and agility, or to put it another way, there may be a level of consumption where the agile (primarily variable cost) way of delivering a service becomes more expensive than the less flexible (significant fixed cost) way.
How Do I Price My Services?
This use case is relevant if your organization needs to understand the profitability of the service they provide; most IT organizations do not operate as a profit center but the concept of “profitability” may still be important. In a chargeback scenario, setting prices based on actual cost and expected demand requires an understanding of the fixed and variable component of your service costs. Since your pricing needs to cover your fixed costs regardless of consumption, if you set prices too low, you risk under-recovering your costs if demand is lower than expected. And under-recovery is just another way of saying unprofitable.
So, does the visibility into fixed and variable costs, and the improved decision making it provides, justify the time and effort required to classify these costs? The answer is “it depends,” and you have to decide when or whether during your TBM journey you want to tackle it. There are trade-offs. Should you take the extra time to do fixed/variable cost classification from the beginning or circle back around and do it later once you’ve established some level of cost transparency? Do your Chart of Accounts or GL provide a sufficient level of granularity that classifying costs is defensible and not built on a mountain of assumptions? These are fair questions that need to be asked and answered as part of implementing Apptio. But don’t assume that classifying fixed and variable costs isn’t worth doing or something you need to talk yourself into. Instead, start with the premise that visibility into your fixed and variable costs is not only valuable but essential to establishing meaningful cost transparency. It should be something you need strong justification to omit.
