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Ian

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4

High Fixed Cost vs High Variable Cost

Why is knowing the cost structure (High Fixed Cost vs High Variable Cost) relevant in profitability cases? Is it because fixed costs are harder to control and in turn, reduce?

Why is knowing the cost structure (High Fixed Cost vs High Variable Cost) relevant in profitability cases? Is it because fixed costs are harder to control and in turn, reduce?

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Hi there,

I wouldn't say it's specifically because fixed costs are harder to control.

Rather, in all aspects of casing you need to understand the nature of the beast better! Segmenting and categorizing things helps you do this. Essentially, it helps you understand where to go next.

My Advice For Cost Cutting

In general, for determining cost issues, you need to break down the problem into a tree/root-cause analysis and ask the highest level (but specific) questions first! In this way, you essentially move down the tree.

How do you identify where to look? Well, you need to look into whichever of the following 5 make the most sense based on where you are:

  1. What's the biggest? (i.e. largest piece of the pie...most likely to change the end result)
  2. What's changing the most? (I.e. could be driving the most and most likely to be fixable)
  3. What's the easiest to answer/eliminate? (i.e. quick win. Yes/No type of question that eliminates a lot of other things)
  4. What's the most different? (differences between companies, business units, products, geographies etc....difference = oopportunity)
  5. What's the most likely? (self-explanatory)

For more background on analyzing costs, look here:

https://www.preplounge.com/en/consulting-forum/structure-breakdown-for-costs-7963

https://www.preplounge.com/en/consulting-forum/inventory-costs-how-to-segment-6861

https://www.preplounge.com/en/consulting-forum/direct-and-indirect-instead-of-fixed-and-variable-6272

https://www.preplounge.com/en/consulting-forum/when-should-i-break-down-costs-as-fixed-and-variable-as-opposed-to-over-the-value-chain-5990

Hi there,

I wouldn't say it's specifically because fixed costs are harder to control.

Rather, in all aspects of casing you need to understand the nature of the beast better! Segmenting and categorizing things helps you do this. Essentially, it helps you understand where to go next.

My Advice For Cost Cutting

In general, for determining cost issues, you need to break down the problem into a tree/root-cause analysis and ask the highest level (but specific) questions first! In this way, you essentially move down the tree.

How do you identify where to look? Well, you need to look into whichever of the following 5 make the most sense based on where you are:

  1. What's the biggest? (i.e. largest piece of the pie...most likely to change the end result)
  2. What's changing the most? (I.e. could be driving the most and most likely to be fixable)
  3. What's the easiest to answer/eliminate? (i.e. quick win. Yes/No type of question that eliminates a lot of other things)
  4. What's the most different? (differences between companies, business units, products, geographies etc....difference = oopportunity)
  5. What's the most likely? (self-explanatory)

For more background on analyzing costs, look here:

https://www.preplounge.com/en/consulting-forum/structure-breakdown-for-costs-7963

https://www.preplounge.com/en/consulting-forum/inventory-costs-how-to-segment-6861

https://www.preplounge.com/en/consulting-forum/direct-and-indirect-instead-of-fixed-and-variable-6272

https://www.preplounge.com/en/consulting-forum/when-should-i-break-down-costs-as-fixed-and-variable-as-opposed-to-over-the-value-chain-5990

Book a coaching with Henning

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There are many reasons for why you want to understand the nature of the cost structure.

Cost reduction is one as you mentioned. Another one is the understanding of operational leverage to grow profitability through increasing sales:

  • An organization with high organizational leverage (high share of fixed costs) can become profitble quickly by selling more. An example would be software companies or airlines. Since costs are mostly fixed (depreciation for the aircrafts, airport fees per landing, salaries, etc.) selling a few % more or less tickets for each plane (utilization) can have massive swings in your bottom line.
  • Companies without leverage have stable profitability independent from the top line. Think about a trader of any sort (commodities, retail store, etc). When selling more they grow their total profit, but the profit margin stays more or less constant.

Understanding this can help you identify the right approach to increase profitability.

There are many reasons for why you want to understand the nature of the cost structure.

Cost reduction is one as you mentioned. Another one is the understanding of operational leverage to grow profitability through increasing sales:

  • An organization with high organizational leverage (high share of fixed costs) can become profitble quickly by selling more. An example would be software companies or airlines. Since costs are mostly fixed (depreciation for the aircrafts, airport fees per landing, salaries, etc.) selling a few % more or less tickets for each plane (utilization) can have massive swings in your bottom line.
  • Companies without leverage have stable profitability independent from the top line. Think about a trader of any sort (commodities, retail store, etc). When selling more they grow their total profit, but the profit margin stays more or less constant.

Understanding this can help you identify the right approach to increase profitability.

(edited)

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Hello!

Those are very different in nature, since variable costs depend on the output.

Hence, different cost structures make totally different business models (e.g., the higher your fixed cost in a transformation or recovery, the more difficult is going to be to turn arround)

Hope it helps!

Cheers,

Clara

Hello!

Those are very different in nature, since variable costs depend on the output.

Hence, different cost structures make totally different business models (e.g., the higher your fixed cost in a transformation or recovery, the more difficult is going to be to turn arround)

Hope it helps!

Cheers,

Clara

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Correct. You want to know the cost structure to see if it is a problem to begin with and then if it will be easy to solve. Theoretically variable costs are easier to control in the short term vs fixed costs. Practically though its a lot more complicated than that.

Correct. You want to know the cost structure to see if it is a problem to begin with and then if it will be easy to solve. Theoretically variable costs are easier to control in the short term vs fixed costs. Practically though its a lot more complicated than that.

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