Fixed and Variable Costs — The Dilemma

Back in my college days, the university required two courses in economics: Macro Economics and Micro Economics. It was hard to reconcile the two courses. What is hard fact in one was flakey in the other – and vice-versa. As a student it drove me crazy.

The problem was viewpoint. Macro Economics approached their issues from a very high altitude. It dealt with general trends and very theoretical issues. Macro started very high level and then drilled down somewhat. Micro Economics approached their issues from the bottom up. Micro dealt with detail then tried to summarize – At least as detailed as any economist can deal with. In the end, there was value in staying aware of both ends of this spectrum.

Fixed and variable costs have the same problem as my university macro and micro economics. The concept of fixed and variable costs comes from the macro end of this spectrum.

From the high level macro view, costs are easily classified as fixed and variable. The company has an output which drives all variable costs. Plot this on a graph with revenue and, bingo bango, there’s your answer.

Now switch to the micro side of fixed and variable costs. Does the company have a single product that drives all variable costs? What about customers? Not all cost varies with product volume; some have only to do with customers and customer support regardless of number of products or volume of products.

What timeframe captures variability? Does a cost change in a week, a month, a year, or years. What is the timeframe for the decision we’re making?

Even in a financial services context, costs are variable to what? Variable to accounts? Variable to new accounts? Variable to transactions? Variable to balances? Variable to channels? Variable to service definitions? Variable to branches?

In the end, we would all prefer the simple problem statements and simple solutions from the macro side. However, the macro side fails to deliver the detail required for most management decisions.

The micro side of fixed and variable costs is business modeling or cost/profit modeling. Here we recognize the interaction of the multitude of currents within a business. Activity-Based Cost Management or ABC is a set of principles and methodologies that assist in modeling the micro side model of a business. Any business with more than one resource, or more than one product, or more than one customer must deal with the micro side.

A well-built ABC model identifies activities that consume the company’s resources then what outputs whether product or customer that best captures each resource’s variability. A well-built ABC model applies cost to these relationships and then compares the cost to revenue yielding profit.

Simply recognizing this macro – micro dilemma is essential. Businesses applying macro fixed and variable concepts directly to micro decisions have a problem and vice-versa. However, recognizing cost variability is essential to good business modeling. We just need to keep the two ends of this spectrum in mind and apply their concepts and tools in the right context just as I had to do back in college with my micro and macro economics courses.