Managing high fixed costs

Knowing your fixed costs can help manage your business more effectively.  Businesses with high fixed costs will have different strategies for managing their business than those with high variable costs.

Expenses are generally categorized as either fixed or variable. Fixed costs are the expenses that are incurred regardless of how much is sold or how much is produced. Some typical examples of fixed costs are lease payments, insurances and mobile phone cap. Variable costs are the expenses that vary depending on your sales or activity level. Variable costs include expenses such as electricity, phone call charges and subcontractors.

Businesses with high fixed costs need to consider some of the following points when managing their business:

• Their breakeven point will start higher than a business with high variable costs. Therefore, pricing strategies may need to focus on volumes and not margins. A webinar, e-book or hosting a seminar are examples where this may apply.
• Similarly, the business will need to make sure they sell enough to cover at least their fixed expenses. A business can achieve this by fixing its revenue stream. For example, the mobile phone industry signs customers to a 24 month plan or a consultant seeking a retainer.
• Higher fixed costs may lead the business to be less flexible to changing conditions.  In an economic downturn, the business may have increased risk or financial pressures if the business cannot reduce the fixed costs as quickly as the drop in revenue.
• Conversely, in a growing market there is the opportunity to make higher profits. Once sales have exceeded the fixed costs then further sales will go straight to the bottom line. The business may seek a different market or pricing strategy to increase sales.
• Entry barriers are usually higher for high fixed costs businesses. This may lead to higher profits due to less competition.

Does cutting expenses always lead to improved profit?

The latest retail figures revealed that sales rose 0.2% in May as people spent more on clothing and in department stores. However, NAB’s monthly survey of business confidence and business conditions showed that profitability is dropping. After seeing all the discounting that department stores have been advertising, it makes sense that profit has been falling even though sales have increased slightly.

If sales remain constant but margins have dropped then the first port of call for businesses is to cut costs. Increasing your profit by cutting operating expenses is generally a wise thing to do, however it may also cause your profit to decrease even more than if you did nothing. This can happen when we cut spending on the resources that give us the edge on our competitors.

Our competitive advantage may come from many different areas. One example for retailers is a high level of customer service. If customer service is your competitive advantage then reducing staff would be one of the last areas you will want to reduce. My cousin works for a major department store and the store cut back the hours of many of its staff. However, the media are now reporting that it is taking an hour to get served. If this is true then it is probably correct to assume that sales are being lost due to the lack of customer service and the bad publicity associated with it.

While it is not possible to know whether the decision to cut staff decreased the profit of the store more than if they did nothing, it does remind us that when making decisions about our business we need to consider more than just the short term profit. The long term effect of cutting costs needs to be weighed against the short term objective of increased profit.

A simple method to ensure you aren’t reducing your competitive advantage:

1. List up to 3 factors that you and your staff believe give you a advantage over your competitors.
2. List the resources and quantity needed for you to maintain that competitive advantage.
3. When deciding on cutting costs refer to your lists to ensure you aren’t reducing your competitive advantage.

This method is obviously not an exhaustive process. It will help you consider what is important in running your business.

Profit is not cash!

Managing your cash flow is one of the most important aspects to running a business. We have seen in the past few years a number of high profile companies that were supposedly profitable go bankrupt.

The cheapest and best source of cash for a business is the efficient management of the cash conversion cycle (or simply the cash cycle). The cash cycle is made up of three core components:

• Stock management (including work in progress)
• Payment of suppliers
• Collection of cash from customers

We need to keep a close eye on these components and the actual cash in the bank. If there are any leakages in these components then we may have additional costs hindering our financial performance. These costs may include extra interest charges for the overdraft, missed opportunities or loss of reputation when not paying creditors promptly.

The cash cycle is the length of time it takes from purchasing your stock till you receive payment from your customer. We can measure this cycle with the following performance indicators:

• Days Inventory – the average number of days your stock is held before being sold.
• Days Receivable – the average number of days to collect cash from your customers.
• Days Payable – the average number of days to pay your suppliers.

The Cash Cycle = Days Inventory + Days Receivable – Days Payable.

Generally, the shorter the number of days the better. However, it is not recommended  that you hold off paying suppliers to reduce your cash cycle. The cash cycle needs to be compared to industry norms as well being reviewed for efficiency.

There is an excel spreadsheet available on the resources page of my website that calculates the cash cycle for you.

Welcome!

Welcome to my blog!

My blog is to provide small businesses information and tools to improve their business performance. By focusing on managing the activities and using different indicators to measure their performance we can get to work on improving your business.

Our first theme is the Working Capital Cycle and we will start more specifically with the Cash Conversion Cycle. The cheapest and best place to increase your cash flow is right here.

Stay Tuned.