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Fixed vs variable costs

Carlos

Hello everyone,

Fixed costs are identified with those which do not increase with output and variable costs with those which do increase with output. This is clear for instance in manufaturing (raw material, distribution, direct labour,... are variable costs and real estate, marketing, ... are fixed costs).

However, for service business this distinction is not that clear to me. For instance, in the case of a bank, adding one more customer (and hence increasing the revenue from fees or interests) does not necessarily increase the number of employees or offices to be handled; considering this labour and real estate could be defined as fixed costs. However, if the number of customers grows significantly the bank will need to increase its labour force and probably also the number of offices. So how would you establish the boundary between fixed and variable costs in these type of cases?

Thanks. Regards.

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Hemant
Expert
replied on 03/26/2018
Current partner @ Andreessen Horowitz (VC firm). Ex-Mckinsey, ex- strategy guy at Google.

The costs you are talking about is also known as CAC - customer acquisition costs. There is literally *no* business where CAC is zero. You spend salespeople's time, marketing $s, advertising, or other $s to acquire this customer.

CAC is therefore always an operating cost and below the line (underneath COGS).

Fixed and Variable costs are about producing the product OR service - i.e., how much does the company spend to create what someone will buy. It is purely a part of COGS.

CAC is about getting that product/service into a customer's hands.

As companies grow, CAC usually goes DOWN even if their company size grows, but it varies if you are an enterprise or a consumer company. SNAPCHAT spends lot less to get a new user now because there is so much more word of mouth. On the other hand, Salesforce is now going after bigger and bigger companies to sell to, so their avg CAC may be going UP.

Hemant

Francesco replied on 03/26/2018
Ex BCG | MBB Specialist | #1 Expert for coaching sessions (1300+) and recommendation rate (100%)

Hi Carlos,

so far that you want to divide in fix and variable costs only, you can use the concept of marginal change in the output. Specifically, you can consider a cost variable if they increase with a marginal change in the output of the product. Thus all the costs that change with a marginal change in the output (raw material for example) can be considered variable. On the other hand, costs that do not change with a marginal change in output (as labour or real estate) can be considered fixed.

To be more accurate though you should introduce the concept of semi-fixed costs. These are costs that do not change with a marginal change in output, but can change if there is a significant enough increase in production. Assuming you have a graph with output on the horizontal axis and cost on the vertical axis, they are graphically represented by increase by steps.

Thus, the most appropriate definition would include the following:

  • Variable costs: change with a marginal change in output
  • Semi-fixed costs: do not change with a marginal change in output, but can change so far that there is a big enough increase in output
  • Fixed costs: never change, whatever the output

Hope this helps,

Francesco

B replied on 03/25/2018
NOT AVAILABLE

Hey anonymous,

A way of dealing with the type of costs that you presenting is to call them by their proper name: semi-fixed (or semi-variable) costs, i.e., their graph looks like a leather, as they are fixed for a certain amount of work/clients/capacity, but then if you want to expand further they become higher. This might seems a very technical discussion, but interviewers might expect from everyone who had studied accounting before to be able to discuss about it.

Best

Bruno

Andrea
Expert
replied on 03/25/2018
I am a former BCG decision round interviewer with 300+ real interviews conducted and 8 years interviewing experience

I actually think you can use the same logic that you use for a manufacturing case - you can only increase production so much before you have to invest in more tooling and real estate. What I would do is to identify how many incremental customers a rep or a server can handle and based on that and what the solution of the case is consider these costs either variable or fixed costs. For example if business is a food delivery service and your ideas to increase revenues results in an increase of revenues of 20% and current service reps have spare capacity of 25% and delivery team has spare capacity of 5%, I would consider service reps as fixed cost and delivery team as variable (then you can further distinguish between salaries, delivery vehicles, gas and mileage).

hope it helps,

andrea

Vlad replied on 03/25/2018
McKinsey / Accenture / Got all BIG3 offers / More than 300 real MBB cases / Harvard Business School

Hi,

For service industries I will use the following:

  • Labor - mainly fixed. Variable in special cases like 2-sided markets (e.g. taxi business)
  • Marketing - Mainly fixed. Variable in case of discounts / subsidizing per order
  • Supplies, distribution - variable
  • Rent, tools, etc - Fixed

Best

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