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The Dangers Of Fixed Cost Creep

Fixed Cost Creep happens when fixed costs increase as sales and activity volumes increase.

This idea may seem strange.

The basic definition of a fixed cost is that it stays constant.

In reality it increases as the business commits to further costs. Hopefully it increases at a much slower rate than variable costs.

Not recognising and adapting to this idea can give a business owner unrealistic expectations about future profitability.

It can also lead to an assumption that fixed costs shouldn’t be or can’t be reduced if volumes are reducing either deliberately or because the business is going through a hard time.

What Are Fixed Costs And Variable Costs?

Fixed costs are defined as costs that do not increase or reduce directly with changes in volume. In contrast variable costs will vary directly with changes in volume.

For more understanding of how costs change see the article:

>>> The Cost Volume Profit Relationship

Why Fixed Cost Creep Exists

In the article

>>> Practical Problems With Break Even Point Analysis

I explain that costs are driven by many other different things than the physical volume of products sold or services provided.

Looking at the list of real world cost drivers, you can see that costs are pushed and pulled by an increased demand for a resource to process something.

I know the word “something” sounds vague but you can see that there are many different cost drivers.

Look at a cost and ask “why do we have to spend that money?”.

For example postage costs are driven by number of sales transactions (as invoices and order acknowledgements are sent out), the number of direct mail letters and the amount of general correspondence.

Anyway back to the idea that costs are driven by a demand for a resource.

Fixed costs are lumpy expenses.

You either have a personal assistant or you don’t. And if you don’t, you do some of the work he or she would do, others do some of the work and some activities you’d ask your PA to do, don’t get done at all.

You could split these costs into:

Amount used doing proper activities + amount wasted = total cost of the resource.

As the volume of the cost driver increases, the amount on proper activities increases and the amount wasted reduces.

Eventually all the waste will disappear as the capacity of the resource is fully utilised. The resource will then try to adapt to the increased volume of output demanded from it. In the case of a staff member, this may involve:

  • working longer hours
  • finding faster ways to do the activity to maintain the high quality and improving efficiency
  • finding faster ways to do the activity by reducing the quality of the work done

A backlog builds up as delays are built in and work doesn’t get done in the time desired.

A crisis point is reached and more resource has to be provided by increasing fixed costs.

This is likely to create some spare capacity in the resource and in effect creating waste and the cycle begins again.

This is fixed cost creep at work, creating a pressure point that can only be relieved by increasing the level of resources.

Other Reasons For Fixed Cost Creep

As well as adjustments to the quantity of resources purchased by your fixed costs, you will also see creep appear in:

The price. There is less pressure to keep costs low if the business is doing well.

The quality of the resource. As the business increases in size and complexity it will need better people who will cost more. Ego may also create a desire for better resources e.g. smarter offices

Discretionary expenses can be afforded. These are the nice-to-have’s that the business wouldn’t buy if it wasn’t doing well.

Fixed cost creep happens because of senior management decisions but each decision feels justified at the time.

In isolation, there isn’t a problem but the cumulative effect of fixed cost creep can have a significant effect on increasing costs, reducing profit and driving up the break even point of the business.

Why Fixed Cost Creep Doesn’t Reduce Automatically If Volumes Go Down

While there is pressure to increase costs as the business increases, there is little pressure to reduce costs when the business is getting smaller except for the reduced profitability.

People still want nice offices and appreciate any extra space they are given.

Few employees will readily go to their boss and ask for more work. In fact, they may not even be aware that they have more spare time.

Parkinson’s Law says that “Work expands so as to fill the time available for its completion.”

This is very true and even a motivated business owner can be shocked at how little can be achieved if time pressure is relieved.

Take writing a blog article for example. If I know the topic well and don’t have to do any research, I can complete a good quality article in 30 minutes or three hours. The one that takes more time is better (or at least longer and more comprehensive) but the shorter one is usually good enough.

Unfortunately it takes deliberate effort and difficult decisions to reduce fixed costs. It’s not very nice work because it’s much nicer to be seen as a generous spender than a mean miser.

This is the problem governments around the world have and they have the added luxury of spending other people’s money. No wonder austerity cuts are hard.

The Dangers Of Fixed Cost Creep

If resistance isn’t put up against fixed cost creep and the pressure to increase overheads, the Break Even Point of the business increases and the business finds it harder to make good profits.

As you hire extra resources, they create extra work in themselves and that puts pressure on other resources.

Inefficiency also builds up. The opportunity for friendly chats increase exponentially as the number of people increases. Responsibilities become unclear and instead of one person doing an entire job, it is broken into different stages and passed from person to person, building in processing delays. Knowledge of what’s happening disperses.

How To Fight Against Fixed Cost Creep

I mentioned earlier that resources adapt as their spare capacity to do work reduces. This pressure will encourage changes in working practices to speed things up. Intuitively it doesn’t sound good to think that the quality of a task will be forced down as less time is available but for many activities, good is often good enough. Work expands to fill the time but it may not be valuable.

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