Saturday, December 14, 2013

The Cost Spiral

I was introduced to the concept of The Cost Spiral back in the mid-80s by an article in the Sloan Management Review.

Traditional micro-economics teaches that there are two classes of costs.

Variable costs are costs that rise and fall proportionately with volume.  Suppose you opened a pizza place.  According to traditional micro-econ, your variable costs would be the cost of ingredients and the cost of labor.

Fixed costs are those costs that remain constant regardless of whether you sell one pizza a month or 15,000 pizzas a month.  Typical fixed costs would be rent, equipment leases, utilities.

It is often possible to make trade-offs between variable costs and fixed costs.  As the business owner, you can buy or lease more sophisticated equipment (at a higher cost) that reduces the need for labor to monitor the process.

Variable cost and fixed cost interact with each other to produce something called the break-even point.  The break-even point is the amount of product that must be sold before the business stops losing money and starts making money.

High fixed costs and lower variable cost raises the break-even point to higher volumes.  It also makes the profit curve steeper, that is, the rate of profit increases quickly past the break-even point.

Business owners are self-selected for optimism.  Pessimists don't risk their money when there is an 80% chance of failure.  As optimists they gravitate, by nature, to higher fixed costs/lower variable cost configurations.

The downside of the high fixed cost configuration is volume less than the break even point results in massive hemorrhaging.   Any financial reserves are quickly consumed.

The Cost Spiral

Traditional micro-economics is a static, set-piece battle plan.  It is a great model for college sophomores but does not capture the complexities of how the business cycle impacts the business.

The cost spiral captures some of those dynamics that occur over the course of the economic business cycle.

The business owner learns that "variable" costs do not vary downward when business is bad.  The business owner finds that he/she cannot depopulate the business as quickly as sales volume fades.  There are residual employee obligations and costs that continue even after the employee is laid off.  Materials become stale or spoil and must be tossed out.

When business picks up, the owner finds out that "fixed" costs are not fixed when business is good.  The pizza oven has a limit on the number of pizzas it can pump out at peak times.  Floor space constraints start making the operation inefficient.  The number of parking places becomes an issue.

Over several business cycles these costs accumulate the way growth rings add girth to a tree.  The sapling that was flexible and swayed before the gale became bulky and inflexible.  Its ability to adapt diminishes.

Fixed Costs

Fixed costs deserve special consideration.  Every cost "wants" to be a fixed cost.  It is almost like every cell wants to become a fat-cell, or every bettor wants to hold the kitty.  It is a risk transfer strategy.  It off loads the risk (uncertainty, variation, noise) from the 'cost' to the business owner.

Like gravity, the pressure from this aspiration to become a fixed cost is relentless.  It is everywhere.  It is in software renewal licenses.  It is in labor contracts.  It is from suppliers.  It is in medical insurance/costs.

There is a secondary cost to letting your "players" become a fixed cost.  Nothing sharpens the senses more than being a little bit hungry. Variable costs is piecework rate, it is the guy sneaking through the woods trying to shoot his next meal.  Fixed cost is pushing yourself away from the table after Thanksgiving dinner.  Which guy do you want running up-and-down the ball court on your behalf?

The cost spiral was suggested as one of the causal mechanisms for why companies grow old and seem to suffer from sclerotic behaviors and balance sheets.  It also happens to household economies.

Be vigilant.

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