Fixed Expense: An Orphaned Concern
The Productivity Double Standard
Across industry, Fixed Expense tends to be treated as an orphaned concern within management systems and improvement methodologies. Compared to the consistent focus directed at reducing Variable Expense in production related areas, Fixed Expense is often referred to as the ‘ownerless’ expense category.
This article explores why Fixed Expense remains marginalized in the competition with Variable Expense as a focus in productivity improvement stakes.
The fantastic growth of Fixed Expense as a share of Total Expense, and continuing confusion surrounding how to manage variable work volumes in areas generating Fixed Expense, means many businesses are allowing productivity to languish across a large swath of business activity. Businesses often apply softer performance standards to work which drives Fixed Expense.
This double standard extends to allowing the utilization of production assets to fluctuate widely, and to holding permanent excess capacity. It's worthwhile remembering that Interest Expense, Depreciation, Amortization and Leasing expenses are commonly a large chunk of Fixed Expense. It's essential in a business review to identify opportunity in the management of capacity utilization.
As a result, many businesses are sitting unrealized opportunity to improve Operating Profit and Return on Invested Capital (ROIC) by between 10% and 30% without raising prices, without capital expenditure, and without reducing service levels.
What is Fixed and Variable Expense?
In accounting parlance, Variable Expense varies directly with the amount of production output in a production system. More or less production output requires more or less materials, more or less labor, more or less power and more or less production time. For example, an increase of 5% in the production output of a business producing flour tortillas will likely result in a 5% increase in the expense associated with procuring flour (all else held constant). So, the expense related to procuring flour is deemed a 'Variable' Expense.
Fixed Expense doesn’t vary as a result of marginal changes in the volume of output produced by a production system. For example, marginal increases or decreases in production output in the tortillas business won't change expenses associated with staffing in areas like Sales or Human Resources. Marginal changes in production output aren’t likely to result in changes to Interest Expense, Depreciation or Leasing expenses (all else held constant). The amount of work generated in Human Resources probably won’t change as a result of a 5% reduction in the number of flour tortillas produced. The expense relating to maintaining the Human Resources function is deemed a ‘Fixed’ Expense.
Fixed Expense is a Misnomer
Contrary to its traditional accounting tag, Fixed Expense is anything but 'fixed'. For example, it's true that the amount of work in a Human Resources (HR) function does not generally vary in relation to marginal changes in production output (for external customers). So, the expense of maintaining a HR function is generally deemed to be Fixed Expense.
However, the work of a HR function does vary directly in relation to the demand for output from other sources. So, instead of looking at production output as a guide for the amount of work in HR, management need to start counting the units of output that do drive workload. This applies to all Sales, General and Administrative (SG&A) functions.
The amount of work in a Human Resources function will vary directly with work drivers like the number of recruitment and exit interviews, training sessions, legal and compliance audits and presentations, psychological testing and compensation reviews, etc.
All work is process. All processes may be improved. How are your Fixed Expense areas evaluating their workload and resource requirements? Management has an opportunity to lift the productivity of all work, including work that generates so called 'Fixed' Expense.
The Rise and Rise of Fixed Expense
Since the first industrial revolution, the exponential rise in mechanization and then automation, followed by the explosion of computer based information technologies and advanced robotics, has significantly increased the amount of Fixed Expense in most businesses.
As expensive production assets proliferate, debt is commonly used to finance their acquisition, and interest expense is a significant Fixed Expense (reflected in the Net Margin). Over decades, we've seen a shift from direct labor, typically a Variable Expense on the Earnings Statement) to Assets and Liabilities on the Balance Sheet.
Automation has significantly increased Fixed Expense such as Interest Expense, as well as Depreciation, Amortization and Leasing expenses. These Fixed Expenses (aka, the cost of capital) used to be reflected more in Variable Expense, as direct wages. With widespread automation and the proliferation of new technology, the roles of Maintenance and Information Technology have bourgeoned, further increasing Fixed Expense.
So, at the beginning of the first industrial revolution, Fixed Expense represented a much smaller share of total expense. It was reserved for a handful of manual work functions which were critical to business ownership and closely controlled by owners and senior managers. As a result, cost allocation was a far less problematic process.
Is the distinction between Fixed and Variable Expense now obsolete (i.e. there was a time when Fixed Expense was considered an undesirable exception to the general goal of holding all production related expense variable).
Given the continuing pace of automation, as well as the advent of Artificial Intelligence, it's likely that Variable Expense will continue to become an even smaller component of Total Expense. Perhaps it's time to rethink the usefulness of the traditional accounting distinction?
Dare we rethink Fixed Expense as being Variable Expense?
The Work which Generates Fixed Expense
Fixed Expense represents most of the expense generated by Sales General and Administrative (SG&A) such as:
Safety & Injury Prevention, Sales, Marketing, Merchandizing, Human Resources, Customer Service, Communications, Public Relations, Investor Relations, Accounting (including Accounts Payable and Receivable) and Finance (including Statutory Reporting, Risk Management, Investment & Self-Insurance), Training & Education, Creating and operating Web-sites, Operating Social Media and Digital Applications, Security, Insurance, Legal Services, Property Management, Logistics, Purchasing, Information Technology, Continuous Improvement, Executive & General Management Services, Maintenance, and workplace Supervision, etc.
So, Fixed Expense is significantly reflected in Operating Profit as SG&A , Depreciation and Amortization, etc. Fixed Expense is also reflected in both the Gross Profit Margin (e.g. supervision and workplace management), and in the Net Profit Margin (e.g. Interest Expense).
The following Fixed Expense is significantly associated with acquiring and holding production related and intangible assets which are used for production:
Interest Expense, (the expense of procuring capital by borrowing money), Depreciation Expense (a time-based non-cash expense for tangible assets which results in a tax benefit), Amortization Expense (a time-based non-cash expense for intangible assets which results in a tax benefit), Leasing & Rental Expenses (long term and short term, time based) for both intangible and tangible assets. Note, these expenses tend to remain constant regardless of marginal changes in production output.
Fixed Expense is often the Largest Element of Total Expense
The literature surrounding management’s efforts towards continuous improvement is myopically focused on reducing Variable Expense. You need only review the focus of projects in Lean Thinking, Business Process Reengineering (BPR) the Theory of Constraints (TOC), Six Sigma, Agile/Scrum (project management) and dozens of other popular improvement approaches. These approaches are usually focused on reducing Variable Expense (or put another way, they are more often focused on raising the productivity of the production processes. This is odd given Fixed Expense may represent the larger share of Total Expense.
Ironically however, as the table below suggests, Fixed Expense is often the larger component of total Expense. So why is Fixed Expense the poor cousin of the improvement focus?
Estimated Fixed & Variable Expense % by Industry
In spite of the size and growth of Fixed Expense in modern businesses, most improvement methodologies and transition events remain focused on optimizing the major Variable Expenses.
Variable Expense includes direct labor, energy/utilities and materials/component expenses. How many ‘broad’ transition programs have you experienced where Fixed Expense was either totally omitted from the transition scope, or left on the ‘back burner’ until improvement efforts relating to Variable Expense were exhausted? Programs specifically seeking a reduction of Fixed Expense are usually undertaken in the wake of some pending or actual financial apocalypse. They are often a last resort applying dubious methodologies which result in choking the wrong resources.
The Allocation of Fixed Expense
Allocating Fixed Expense from all of its sources to the business and product level is necessary for budgeting and determining Total Expense at the product level. Knowing the Total Expense of individual products is essential for determining product profit margins and product pricing. Allocation is also essential for the budget process, ensuring that different business units understand Total Expense and Profit goals.
If management don’t understand profitability at the product level, the business is vulnerable to price ‘cherry picking’ by customers (where prices are too low), and price undercutting by competitors (where prices are too high). That’s a core strategic risk.
Unfortunately however, the act of allocation may undermine the sense of ownership and responsibility for managing Fixed Expenses. Fixed Expense really ‘belongs’ to the area where the expenses were originally incurred. However, if a production or business unit, or its products, are loss making after the allocating Fixed Expense, where will improvement efforts be focused? Will the spotlight fall on those generating Fixed Expense or Variable Expense?
In reality, it's far more likely that focus will fall on reducing Variable Expense. Variable expense is more easily identified. Accountability is clearer in an organizational sense. Productivity standards and variances are likely established and more visible.
By contrast, the aggregate of Fixed Expenses which are allocated to business units, and products may emanate from dozens of different sources in the organization. Accountability is diffuse. Management systems are relatively weak.
In a review post allocation, it's harder to pinpoint which areas of SG&A were unproductive. Perhaps more than one. There may not even be productivity standards or variance reporting in many SG&A areas. Work volume may not even be quantified. On the asset side, where Interest Expense is generated, was asset capacity utilization too low, resulting in bloated Interest Expense? Who's accountable for repairing that problem? Sales? Mergers and Acquisitions? Who owns it? Maybe a previous generation of management.
Who hasn’t heard operations management complain that head office allocations of Fixed Expense are excessive and/or unfounded? When products are determined to be loss making following cost allocation, continuous improvement efforts typically favor chasing the Variable Expense component for waste.
Which is more likely, a concerted effort to reign in unnecessary Fixed Expense in Human Resources, Information Technology, Finance, Sales and Maintenance areas, or another productivity transition project focused on Variable Expense in production areas? You know the answer.
Most business systems are designed to identify problems relating to the productivity of Variable Expense. In areas responsible for production output, there are likely to be formal performance Standards, Quantified work volumes, Bills of Materials, Standard Routings, Service level Standards, Standard Operating Procedures, and dynamic systems for Materials and Logistics Management. Add, Work Volume Forecasts, Resource Plans, Production Schedules, and a formal Performance Reporting and Review System.
By contrast, the opportunity to reduce Fixed Expense is shrouded behind a lack of effective productivity system elements and disciplines in multiple support and service functions. How is work volume measured in these areas? How are resource levels planned? How is efficiency measured? How is quality measured? How is downtime measured? How are service levels measured? How is skills flexibility managed? What performance did we expect to see exactly?
As work levels vary over time, how does management in the Fixed Expense area vary the resource level? I hate to break it to you. Sometimes, there isn't much science attached.
‘Bread and butter’ Productivity questions in the management of Variable Expense make it the ideal scope for savings and waste reduction.
When Allocation Fails: Embrace the ‘Contribution’ Margin
Put aside for a moment the inherent lack of management structure around optimizing productivity in areas generating Fixed Expense. In addition to Fixed Expense becoming bloated and standing unchallenged, allocating Fixed Expense to the product level can be complicated and time consuming, especially if there are hundreds of products/SKUs. In fact, allocation can become such a hit and miss affair, management (and Finance/Accounting) can (and do) simply give up on efforts to calculate the Unit Profit Margin.
Methods used to allocate Fixed Expense can result in product costs and margins being roughly estimated at best. In some businesses, Fixed Costs may never be accurately allocated to the product level and the Unit Profit of individual products is simply unknown. It’s not unusual in these circumstances to find that over 50% of products are unprofitable, with many more breaking even or only marginally profitable.
The formula for calculating Unit Profit is:
Unit Profit = (Unit Price – (Unit Fixed Expense + Unit Variable Expense)
So, to calculate Unit Profit, the business needs to be able to allocate Fixed Expense to the product level. In businesses where cost allocation is infrequent and/or inaccurate, it’s common to see management abandon real attempts to calculate Unit Profit. Alternatively, it's garbage in, garbage out. When this occurs a business may retreat into calculating only Unit Contribution.
The formula for calculating Unit Contribution is:
Unit Contribution = Unit Price – Unit Variable Expense
While you’ll hear a lot of half baked justifications for calculating Unit Contribution, it’s a half measure which omits any mention of Fixed Expense and fails to determine profitability at the product level. It refers only to Variable Expense. It doesn’t allow a determination as to whether a product is or is not, profitable (because Fixed Expense at the product level is unknown).
The Contribution Margin merely indicates whether the ‘contribution’ to covering Fixed Expense has risen or fallen over time. Unfortunately, the Contribution Margin of any product may rise dramatically, but that product may remain dramatically unprofitable.
Add, it suggests that the only control points for reaching product profitability are Variable Expense and Price. What prompt for managing Fixed Expense is offered by the Contribution Margin? None. If a business has adopted the Contribution Margin, it may have abandoned active management of Fixed Expense.