Dr. Albert D. Bates
President, Profit Planning Group
Boulder, Colorado.

The sales challenges associated with the recession have caused most firms to take a serious look at their operating expenses. Obviously, most of the effort has focused on cutting ex­penses. While that is an important task, a more fundamental issue is determin­ing the nature of the firm’s expense structure. That is, deciding whether the organization should build a heavy fixed-expense structure or whether it should rely more on variable expenses. 

Examining the expense structure is not an academic issue. The ability to put in place an expense profile that reflects the firm’s strategic posture is essential to long-term success. It also has major impli­cations for the ability of the firm to withstand current and future economic challenges.

This report will examine the ex­pense structure of EASA members based upon the 2008 Operating Per­formance Survey Report. By defini­tion the discussion will be somewhat technical. However, it is extremely important. The report is organized into two key sections:

• Why the Fixed Versus Variable Distinction is Important—This section will analyze how chang­es in the mix of fixed expenses versus variable expenses alter the firm’s response to different economic conditions.
• Changing the Expense Struc­ture—This will provide a road map to the actions that can help the company alter its basic expense structure.

Why the fixed versus variable distinction is important
There is probably no subject duller than an analysis of fixed and vari­able expenses. However, the fact that almost nobody can agree on what these expenses are makes it a relevant topic of discussion. In addition, the organization’s success depends upon how expenses are structured into these two categories.  Simply put, the two expense groups respond in very differ­ent ways to changes in sales:

Variable expenses—These are ex­penses that automatically rise or fall as sales rise or fall. That means that man­agement does not have to do anything to cause these expenses to change. The classic variable expenses are sales commissions, bank-card charges, bad debts, interest on accounts receivable and a few other miscellaneous catego­ries. If the expense does not change automatically with an increase or decrease in sales, it is not a variable expense.

Fixed expenses—These are ex­penses that only change if manage­ment takes action. In a severe eco­nomic downturn, no expense category is sacred.  However, fixed expenses do not fall until management forces the issue.

At this point a deep philosophical question comes to mind—so what? That question is addressed in Exhibit 1 which ex­amines the operating performance of a typical EASA member and two scenarios that the firm might consider for its mix of fixed and vari­able expenses.  

The “Typical Vari­able Expenses” col­umns in the middle of the exhibit repre­sent the typical firm in terms of where it is currently and where it would be if sales declined by 10.0%. In this example, variable expenses account for 5.0% of sales. The bottom-line profit for the firm is 5.0% of sales, the EASA norm.

In the “Light Variable Expenses” scenario, the firm has altered its ex­pense structure by converting variable expenses to fixed expenses. While total expenses remain the same, the vari­able expenses portion now represents only 2.5% of sales. The rate of variable expenses has been cut in half.  In the final two columns the process has been reversed and variable expenses now account for 10.0% of sales.

The “so what” occurs when sales fall. As shown in the two “Typical” columns, the 10.0% sales decline causes profits to fall from $250,000 to $75,000, a reduction of 70.0%. This assumes no actions are taken by management to reduce fixed expenses.  It is the direct result of the sales decline and the as­sociated decrease in variable expenses.

In the “Light” scenario, where vari­able expenses have been converted to fixed expenses, the same percentage decline in sales caused profits to fall by 75.0%.  In the “Heavy” scenario where variable expenses are emphasized, the profit decline is 60.0%. While this is still severe, it is certainly less traumatic.  Comparing the “Light” variable ex­pense column to the “Heavy” one, prof­its—after the sales decline—are $37,500 greater with a variable expense-based expense structure. It is the difference between laughing and crying.

The action of converting fixed ex­penses to variable is a very legitimate un­dertaking. The result will always make the firm less susceptible to economic downturns. Nothing will completely shield the firm from a sales decline. However, with a greater emphasis on variable expenses the firm will auto­matically enjoy higher profits than they otherwise would when sales decline.

There is, of course, no such thing as free lunch. During a period of sales growth, having a heavy proportion of variable ex­penses will limit the up­side impact on profits of the sales gain. When the expense structure is driven by variable expenses, the firm is buying insurance against a sales decline.  It pays for that insurance with the profits not generated during periods of growth.

Changing the expense structure 
Most organizations have more of an ability to adjust fixed and variable expenses than they appreci­ate. The opportunities arise in two, relatively similar-sized categories.

Sales Force Compen­sation—More aggressive salespeople tend to flock to commission-only plans which they feel maximize their personal compensation.  Most other salespeople pre­fer a base and commission plan as it affords a certain degree of security. Many firms end up with a combi­nation of plans. However, in doing so, they have the worst of both worlds.
When sales rise, the commissions tend to accelerate automatically. When sales fall, high performers continue to generate sales and commissions while poorer performers fall back on the base salary to the detriment of the company. No single area of expense structure planning is more important than compensation of the sales force.

Other Expenses—Converting vari­able expenses to fixed expenses is easy.  Converting fixed expenses to variable expenses requires extreme creativity.  Piece-rate programs can be established, delivery activities can be outsourced and even rent can be restructured.  The only limit is the desire of the firm to make such changes.

Moving forward
Deciding upon the appropriate mix of fixed and variable expenses is one of the most important long-term decisions the company will make.  The trade-off is one of moderating profits—neither exceptionally high nor low—versus enjoying spectacular profits in up years and terrible profits in bad ones.  It is a trade-off that every firm should make consciously.  

Categories: Technical topics

Tags: Profitability

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