Variable costs are something that all entrepreneurs should hold in awe. In simple terms, they are corporate costs that vary in direct proportion to the volume of goods and services produced. Common examples are the cost of raw materials, labour and shipping. Yet businesses, particularly startups, often fixate on volume.
Economies of scale, of course, make a vast difference to cost structures. It’s how internet companies build their business models at an early stage, counting on upscaling as much as possible – ideally to the point of monopoly.
Once businesses have streamlined their fixed costs such as IT infrastructure expenses, they can adjust the variable costs to increase marginal profits. After all, the bigger the pot, the more to put in it. In reality, though, many companies, whether they’re players in the traditional sector or internet-based tech businesses, have far too little understanding of variable costs and so pay equally little attention to them.
Achieving a positive net profit margin is a false proposition if the gross margin is too low
Tinned trouble
In the traditional sector, I once had a client who sold canned meat. Attracted by the fashionable design and premium quality of the product, the company’s customer base was a loyal one, despite the high price tag. However, corporate profitability was weak. The CEO, distressed and anxious, often complained to me how bad money was driving out good. After investigating, though, I found that the issue lay instead with the company’s variable costs.
First of all, in order to highlight the quality of its product and to differentiate itself, the company would use only imported meat. But imported meat was not only far more expensive to buy than domestic meat, it also incurred additional costs from the cold-chain logistics required.
The more the company sold, the bigger the loss it faced
Second, because the company lacked manufacturing capacity, it had to outsource production. Since its niche customer base meant only a limited volume of orders, the company had insufficient bargaining power with manufacturers, so production costs were high. During peak business periods, manufacturers would raise their prices. And when its competitors in the canned-meat sector lowered their prices, my client was forced to play along with various promotions, which exerted a further drag on profitability.
After some calculation, I worked out that the company’s gross margin was less than 20% after deducting the variable and fixed costs. Based on previous experience, I knew that such a low level was unlikely to leave the business in positive net profit. To put it another way, the more the company sold, the bigger the loss it faced. This was not an issue of bad money driving out good at all. Instead, the root cause lay in a problematic cost structure.
Double drag
Another example is an internet company I worked with. It was an online platform for midwifery services, with promising positioning and value-added services that could create cohesion along the supply chain. However, after reviewing the cost structure, I knew it wouldn’t be easy for the company to maintain profitability, as it needed to pay commission to both midwives and client-referrers. As a variable cost, the price of customer acquisition was just too high.
To companies with an internet mindset, achieving a positive net profit margin is a false proposition if the gross margin is too low. However, in the eyes of most internet entrepreneurs, transaction volume is the be-all and end-all. As long as their market share keeps growing, they will have a say in that market, which gives them bargaining power. And as long as customers are prepared to accept the pricing, variable costs won’t be an issue to the business.
