Fixed Cost Creep describes the phenomenon of how fixed costs increase as volume increases.
This contradicts the basic definition of a fixed cost but it reflects the facts of life in the real world.
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.
Why Fixed Cost Creep Exists
In the article Practical issues And Problems With Break Even Analysis I explain that costs are driven by many other different things than the physical volume of products sold or services provided.
"Activity based cost analysis showed that costs tended to vary on different bases:
- on volume
- on batches
- on products
- on transaction numbers
- on complexity of transactions
- by sales value
- by number of customers
- by contribution value (e.g. sales commissions are best calculated this way)
- by combination measures e.g. transport cost may vary based on tonne-mile or tonne-hour. The lorry is limited for what it can carry by weight but the time (and much of the cost) is driven by distance travelled or time spent travelling to allow for congestion.
- and many other different drivers of actual cost."
Looking at that list, you can see that costs are driven by a 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 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 can see these costs as:
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 waste will disappear as the capacity of the resource is fully utilised. The resource will then adapt. 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
- finding faster ways to do the activity by reducing the quality
But a backlog builds up and delays are built in.
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.
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.
Have You Experienced Fixed Cost Creep?
Do you have a story to share about how fixed costs increased unexpectedly and created a problem when you thought your business was prospering?