“On the internet, companies are scale businesses, characterized by high fixed costs and relatively low variable costs. You can be two sizes: You can be big or you can be small. It’s very hard to be medium. A lot of medium-sized companies had the financing rug pulled out from under them before they could get big.”— Jeff Bezos
A high-fixed-cost business is one that has most of its costs unchangeable in any short period of time. Airlines businesses are a good example. Aircraft, terminals, maintenance facilities, and other essential business components take years to build up and become operational. They are not designed for a world in which demand drops by 75% to 95% in a very short time, with little realistic hopes that any significant recovery will occur soon enough to allow resumption of profitable high-volume operations.
These businesses are designed specifically (and usually implicitly) for a relatively stable, predictable business environment over long periods. They can absorb minor disturbances, even wars, so long as there is enough base demand to cover costs, probably helped by borrowing. Maybe a 10% or 20% drop in demand can be managed, especially if recovery seems probable before too long.
Ask the dinosaurs who owned the world around 65 million years ago. One gigantic kaboom and their lifestyle became almost instantly obsolete. A high-fixed-cost lifestyle, in effect.
High fixed cost businesses are inherently fragile.
Today, demand has dropped hugely and precipitously for much of retail and non-essential consumer services. Restaurants designed to be very profitable operating near 100% of capacity cannot survive even at a 70% of capacity. They can reduce staff but this may account for perhaps 30% of overall costs. The remaining 70% of costs cannot be reduced much in any short period of time, and perhaps not ever.
Two types of high fixed cost businesses: Which one are you?
Some businesses require huge front-end expenditures just to become operational. Airlines, hospitals, hotels, office buildings, web-based platform businesses like Amazon, Uber, and Salesforce are examples. Once the upfront costs are invested, they become largely sunk costs that often cannot be recovered or greatly reduced under bad conditions. Variable costs thereafter may be relatively low. Think Amazon. Or very high: Think any airline.
The other type of high fixed cost business is one in which are large portion of essential operating costs are fixed. Rent, mortgages, utilities, property taxes, insurance, salaries, advertising, and maintenance are typically fixed costs that must be paid monthly in many cases. They are typically cash costs that must be supported by ongoing business operations.
Sunk costs can often be ignored post-sinking since they don’t impact operating cash flow. It is the cash-eaters that are the business killers in downturns.
Good times eventually end
A critical but very common management error is planning for a fairly narrow range of operating conditions. Stability, but with manageable variations. The assumption here is that major disruptive downturns are rare – unlikely enough that they can be effectively ignored.
Long periods of stability and steady growth persuade us that these conditions will persist indefinitely. We might do risk analyses for regulatory and operational purposes but these analyses rarely address the foundations of the business itself.
Especially in businesses that have high front-end costs, the business itself becomes a given. We are always going to be a hotel or restaurant chain, a big manufacturer, a major airline terminal. Planning is based on this stable and forever foundation. Until a black swan or other unlikely event comes along.
We can deal with it if it ever happens.
Well, it just happened
Painful learning experience, assuming we can survive. And assuming we do learn.
Most high fixed cost businesses are stuck with their stable-world structure and economics. Cutting losses quickly and substantially may be impossible since the whole business structure in so intertwined. It stands or falls as a unit. So, can we maybe just muddle through and hope for a near-term recovery?
The option of hoping for better times while continuing to operate and absorb huge annual losses may lead too often to bankruptcy and in many cases, liquidation. Dinosaur-ville. Reduced operating cash flow and financings can buy survival time for a while but for most businesses, such time is short.
This point will be addressed in more detail in a subsequent post: “What is Your Survival Horizon?” High fixed cost businesses are typically inflexible over anything but short periods of major disruption. Their resilience is very limited in most cases.
Uncertainty and unpredictability compound the problem
Not only are we experiencing a major downturn, we have very little sense for where things are headed – even in the quite short term. Unpredictability rules. And what little we can see ahead is clouded by great uncertainty.
Changes are occurring too quickly for many businesses to respond in a timely manner even if they had a clear game plan in hand. High fixed cost businesses particularly have great difficulty in making fast responses.
Many businesses today are making minor adjustments in the hope that conditions will soon stabilize or even return to normal. Too often, this is the very best that they can manage. This is in effect a big bet on hope.
Hope is not a plan?
Hope is simply planning to act on some typically implicit assumptions about the future. It is in fact a plan. The problem with acting based on hope is that what you are hoping for may be wildly unrealistic. Which you learn the hard way.
These implicit assumptions need to be made explicit so that they can be examined. Hoping for things to return to some sort of “normal”? This means assuming that the past will come back. Wanna bet, as they say in France?
Hope can be an expression of optimism that we can somehow find a way through whatever is happening out there. Optimism is very good, essential in fact. But optimism is an attitude, not a plan.
Most of us are dealing every day with fast, major changes that are largely unpredictable. What we can see ahead carries great uncertainty as to direction and magnitude.
This is truly a new, different business world that requires new and different approaches. What worked in the good old days probably won’t work going forward.
Time is vital for survival
Our biggest enemy in being able to respond effectively to whatever is happening as it happens is time. Given a year or two, we can likely develop and execute a good plan. But given a moving window of weeks or months at most, what can we do? Mostly, we just wing it, improvise. Not generally regarded as a sound management practice but when you have very little choice, you do what you can.
High cost businesses where the high costs are largely sunk (past) costs – airlines, car rentals, hotels, and the like – may still have a relatively sizable set of operating costs that can be readily reduced. Layoffs and facility closings can be used to help bring residual operating costs more closely in line with reduced revenues.
This works up to a point but even parked planes and cars, and shuttered buildings, still require maintenance, security, and lease or loan payments. If the downturn is severe and extended, these costs alone can kill a business.
High cost businesses where the high costs are operating costs typically have much less flexibility or resilience. Restaurants and even health care businesses can lay off nearly everyone but still face heavy cash outlay burdens each month.
In practice, it is the high fixed operating costs that kill you, regardless of any sunk costs that are operationally irrelevant.
Managing both variable and fixed costs
Operating costs are mostly cash costs. Rents, lease payments, electricity, communications, maintenance, security, insurance, interest – there is a very long list of operating costs that must be paid currently in order for the business to survive. Strong businesses can bridge for quite a while by borrowing, selling investments, and tapping cash reserves. Small and weak businesses can run out of bridging space very quickly.
Layoffs can buy time for a while unless there is a base level of staffing required for the business to function even minimally. Layoffs may well become permanent as the business downsizes to its new lower revenues flow. This is in fact a major business restructuring that will often change the very business itself.
Renegotiating loans, leases, and other contractual costs may be possible to some extent but this takes time and effort away from the business.
Closing facilities may remove staffing and related costs but the facility monthly costs typically remain. These costs are the drivers for many bankruptcies.
Doing whatever needs to be done or can be done buys vital breathing room while more lasting adjustments can be developed and implemented. Again, time is the great enemy of survival.
Using your breathing time effectively
Many businesses will not take the proper advantage of whatever breathing time they are able to obtain. They will treat this situation as temporary and simply try to wait it out. The Old Normal will surely return, soon. Surely.
Whatever time you may be able to arrange, it has to be immediately put to work building a new business structure that is well-adapted to your new business environment. This kind of business reinvention takes time and you need all the time you can get.
One approach that many will implement is to convert as many fixed costs as possible to variable costs. Tech support, customer service call centers, product development, maintenance staff, and similar business functions can often be outsourced at a lower cost than their in-house counterparts.
Inventories can be reduced to move them in line with current sales. Facilities can be consolidated and closed locations can be sold or rented even at a loss.
These fall into the no-brainer category for most business owners and managers. They can buy precious time while the business … does what? Waits or hopes for the return of better times? Let’s hope not.
What is needed now goes far beyond adjustments and waiting it out. The time you are buying should be used for business reinvention.
A retail business may have to restructure so as to provide much better online shopping and pickup/delivery services. This probably needs to be set up as a continuing operation rather than just a peripheral or short-term step.
A manufacturing business that feeds into a sharply-declining retail marketplace may need to shift quickly to services for that customer base, delivered either directly or through suitable retailers.
A healthcare business may need to broaden its services and to include more that can be delivered remotely. Some professional staff may need to become contractors instead of full-time employees. Offices may need to be reconfigured for much greater patient isolation.
These simple examples should illustrate the main point that the breathing time you have should be used to redirect and restructure your business to match the changed and changing environment you face.
Some changes will be relatively minor and easy. But others, and probably those that are most important, will require substantial time, effort, and creativity. The latter will in effect reinvent your business. This reinvention may be largely invisible rather than following any documented grand plan. It may simply evolve.
This breathing time is so precious and limited. Don’t waste a second of it.
I just about forgot the most important ingredient:
Creativity, innovation. If you are not strong here, you are likely to be toast. What you need more than anything (apart from some breathing time) is a group of your best folks who can drive the real-time reinvention of your business. These people can be found at almost any level but the majority will be close to customers and products. They will be independent thinkers.
These will be the ones who know what customers want and what customers may be newly struggling with. Strong product people will know which products fit the changing needs and which ones to drop.
Does your business have this innovation team in place and operating today?
At least one of your major competitors will.
Do whatever you can to buy time so you can develop effective ways to reinvent your business. High fixed costs should be replaced as much as possible with variable costs. Weaker products and operations should be eliminated so as to concentrate on a sustainable core. You may not get another chance.
The Atlantic magazine has a very timely and different point of view on how high fixed cost businesses might be assisted during government-mandated shutdowns: “How to Solve the Fixed-Costs Crisis”:
“Note, also, how this challenge differs from that of a typical debt crisis. Interest payments on debt are one form of fixed cost, and a firm that takes on too much debt can find that even a small downturn in sales—or even no downturn at all—leaves it without enough gross margin to cover the interest owed. But here, with revenue collapsing to zero, through no fault of the business owner, the crisis has nothing to do with excessive leverage. Even if the coffee shop borrowed responsibly, or didn’t borrow at all, other fixed costs could still become crushing.”
Accenture has a very good paper on what it calls the “variabilization” of major fixed costs, noting that:
“But fixed costs can be transformed into variable costs through a process known as variabilization. Organizations that variabilize their fixed costs can master the business cycle rather than be whipped by it. The technique can be applied within your own organization (back-end variabilization) or leveraged to create value-added solutions for your customers (front-end variabilization).”
“In fact, fixed costs have increasingly become a liability. They turn market declines into significant losses. They restrict agility. Many challengers with novel business models have succeeded because incumbents, tied down by fixed costs and fixed assets, could not outmaneuver the newcomers. Even in expansionary times, when fixed costs provide a leverage point for profits, such costs might also constrain the growth of companies that cannot scale up their activities fast enough.”
Railway Age gets into the real nitty-gritty for very high fixed cost railroads: “Managing Costs During A Pandemic”:
“North American rail managers are good at managing costs, but 2020 might be their ultimate challenge. Let’s say you are in charge at a freight railroad. What do you do in such hard times with so many fixed costs? You can ratchet down variable costs. That’s easy. The tougher part is twisting a large part of those fixed costs into segments of variable costs. How do you do that? Let’s start by defining what these railroad costs are. A freight railroad’s cost structure is a blend of common costs—sometimes called joint costs. In addition, there are some geographic sectors of solely allocated costs. Then there are short-term variable costs. Finally, railroads have a large segment of what economists call completely fixed costs.”