Tuesday, May 5, 2009

Profitability Analysis Framework, pt 2 - Fixed Costs: Capacity and Investment Decisions

Profitability Analysis Framework Series
[ 1. Overview, 2. Fixed Costs, 3. Variable Costs, 4. Sales, 5. Price ]

Total costs are composed of fixed costs and variable costs. In this post, we will decompose total costs and focus on fixed costs. Fixed costs are composed of assets for whom increased production does not influenced total costs and includes items such as administration, sales and marketing, land and equipment. Fixed costs usually involve some form of previous investment decision (having financed the purchase of a factory). Or other costs such as management and administrative costs as well as sales and marketing for building brand equity.
While the diagram above is probably the most boring graph you have ever seen, we will use it as a foundation for building the rest of our framework. Note that the fixed cost is constant regardless of quantity. Investment decisions will affect how this line moves up or down on the graph.

However, looking at the individual performance of fixed costs as it's own class of expenditure, the key metric with regards to fixed costs is actually not total fixed cost, but rather average fixed cost.

Average Fixed Cost = Total Fixed Cost / Quantity Produced

Since fixed cost does not change with quantity produced / sold, the only way to improve the operational advantage of a fixed cost outlay is to ensure that the resource cost (and benefit) is spread over as much of the good or service produced.

The following are specific examples of how this applies to different classes of fixed cost allocations.

Land and Equipment
Usually looking at this area is a result of cost cutting measures.
  • The company is thinking of opening another plant or reducing capacity.
  • Analyzing these performance metrics (such as output versus equipment) should tell a story regarding the operational capacity of equipment. If your relative cost of equipment is too high, you might have too much capacity and you can consider divesting equipment, or leasing your capacity.
Sales and Marketing
Investigating this area is usually a result of discovering a weak profit margin or product line. Cost savings from reducing sales and marketing budgets is generally a bad idea (you can't shrink yourself to greatness).
  • Sales and marketing might be a place to focus as brand equity is dramatically inter-related to many other interesting aspects of products (such as pricing and service).
  • A high sales and marketing budget might allow for higher sales margins (or sales numbers) in the revenue side of the equation.
Management and Administration
  • If a company has a very high cost in this area versus competitors, it might be a sign of operational inefficiencies (bloated management layers, practices or compensation).
Now that we have taken a quick peek at fixed cost, tomorrow we will look at variable costs.

[Case Study] One prime example of fighting fixed costs is in the semi-conductor fabrication industry where there are only a few major players (Intel, AMD, Texas Instruments etc). Fabrication facilities have exorbitant and prohibitive capital requirements.

They also have incredibly low variable cost (the individual products of these fabrication plants are relatively worthless). In order to keep a good profit margin, the capacity of the plants must be running at near 99%.

While each of these three major players has high demand, they cannot fully satisfy the demand requirements themselves (resulting an a high average fixed cost per product).

However, by outsourcing their facilities to other semi-conductor designers, they are able to increase the volume and quantity coming out of their facilities (lowering their average fixed cost). They also have a schedule of production queuing to ensure that the facilities always have work to do (to ensure 99+% of the capacity is always utilized).

Profitability Analysis Framework Series
[ 1. Overview, 2. Fixed Costs, 3. Variable Costs, 4. Sales, 5. Price ]

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