The Business Model as we Know it
When we talk about costs in business, we talk about fixed costs and variable costs. A fixed cost is a cost that you incur whether you conduct any business or not.
If you have rented an office, that is a fixed cost. It does not matter from the property owner’s perspective whether you do any business or not; they are going to get their rent. In traditional economic theory, when we want to find out how healthy a company is we calculate what is called the break-even point, the BEP.
Break-even is only possible if a firm’s prices are higher than its variable costs per unit. If so, then each unit of the product sold will generate some “contribution” toward covering fixed costs. A profit or a loss has not been made, although opportunity costs have been “paid,” and capital has received the risk-adjusted expected return. In short, all costs that needs to be paid are paid by the firm but the profit is equal to zero.
Here is the formula: BEP=FC/(1-VC/S)
Where, FC is Fixed Cost, VC menas Variable Cost and S stands for Sales. The break-even point is therefore equal to the fixed costs divided by 1 minus the variable costs percent divided by the sales.
Suppose we have a company that has fixed costs of $500. Now let’s say that for every dollar the company sells, they have to spend 20 cents. Therefore, their variable cost ratio is 20 percent, or to put it another way, they have a profit ratio of 80% on each sale made.
To calculate the break-even point, all we have to do is divide $500 (the amount of fixed costs) by 80% (the profit margin on each sale). The break-even point for this company is $625.00 [$500/(1-20¢/1$)=$625.00]. If this company has sales of $625.00, then they will be profitable and can pay their fixed costs and their variable costs. That is their break-even point.
Improving Your Break-Even Point
What this formula tells us is that if you want a very good business, you want the break-even point to be very low. Then you don’t have to get that many sales before you start making money.
To achieve that, what you need to do is decrease the fixed costs. If you can take your fixed costs and turn them into variable costs, your break-even point will go down. Converting fixed costs into variable costs will improve your break-even point!
If you have no fixed costs, what is your break-even point? Zero! So that makes it very simple. If you do not have any fixed costs, you can’t lose any money. Check Graph A above: When fixed cost is zero, the total cost curve pivots to coincide with the revenue curve. If you just sit there and do not do anything, you are not losing any money. Now that is why everybody is thinking about outsourcing.
Outsourcing converts fixed costs to variable costs, improving your company’s break-even point.
When you outsource rather than pay somebody in-house to do it, which is a fixed cost, it now becomes a variable cost. Therefore, if your sales go down, you are still profitable.
Put simply; the lower your fixed costs, the higher your profitability. Therefore, you want to start thinking about ways to decrease your fixed costs.
Fixed costs going down is a good thing. It lowers your break-even point and improves profitability. The trend of the economic world today is that fixed costs are out.
Getting Rid of Fixed Costs
Let’s do some thinking exercise. How can we get rid of your fixed costs? What can we do? Outsource, of course.
I want you to write down on paper, “Outsource everything, including yourself.” You think I am joking. How do you outsource yourself? You can become a vendor that provides services to your company on a contract basis instead of being an employee.
It is not just other people who can be vendors; you can be a vendor. I believe that in the future, everyone will be an independent vendor. We are moving from a dependent paradigm to an independent and interdependent paradigm.
In the future, every individual will be their own business!
The dependent paradigm is the paradigm of parent and child, which says, “I will take care of you, but you must do what I say.”
This is the traditional paradigm of the employee/employer relationship. Do you know what they call the employee/employer relationship in the law? The law of masters and servants. Yes. Until very recently we had a statute styled Masters and Servants Act in Zimbabwe! Is that shocking? Reserve your shudders for the future. We are moving away from a masters-and-servants paradigm. The reason is that companies can no longer be the parent, because of global competition.
The fact is technology is advancing so rapidly that entire industries now become irrelevant and can no longer guarantee they can take care of you forever. Industry says, “You know we can work together while it is profitable to do so, but I don’t know what is going to happen three years from now. I really don’t. We could be in the business of making telephone handsets, and somebody could invent a cell phone. We could become completely irrelevant, and in this case I can’t take care of you. Peter Drucker, the renowned management guru, surmised that the average life span of the modern business corporation is 30 years.
So we now need to be independent. You need to be able to take care of yourself. But we can work together, which is called interdependency. We can work together while it is profitable for us to do so. We are moving to a different paradigm.” So we are all outsourced.
You need to be independent, because now we are all outsourced!
Now, if the company is the parent and the parent is becoming less stable, then the child cannot depend on the parent, so the child must quickly become independent, meaning that they can provide for themselves. The company is required to outsource, and the child must become independent. Yes, we all must become adults very, very quickly now. We must become economic adults who are able to be responsible and work together in a responsible manner. The social contract has shifted, for better or worse. I am merely describing the world as we work and live in it.
We all must become economic adults!
Now what other ways can you reduce your fixed costs? Outsourcing is not the only way. Think hard. You can reduce your rent, downgrade your offices. You know, Peter Lynch, one of the greatest US stock investors, says that when he goes to visit a company and it is in very flashy offices, he runs for the door. Why? Because they have got to work really hard just to pay the rent. You are not in the business of making your landlord wealthy. You are in the business of making you and your shareholders and your employees wealthy. That is another way to decrease fixed cost. How else can you do it?
How many copiers do you have in your company? How much is your monthly spend on tonner, on servicing, on the copying staff? You get my drift: Outsource equipment use or use equipment that is used only on a when-needed basis. That is variable cost.
How else can you get rid of your fixed costs? You can downsize and get rid of all your fixed costs entirely. Which fixed costs? Salaries. So what is a way you can take a fixed salary cost and turn it into a variable cost? You can pay your people in stock options—which are only going to be valuable if your people make you a bunch of money. Or you can give them a commission or a percentage of profits. You can create a larger bonus pool and a lesser salary, but then the bonus pool depends on the profits. So unless you are profitable, you don’t have to pay them. Would that increase your profitability, yes or no? Yes. You have to have many ways to do it.
What is it all about?
What I am saying is that the Adam Smith economic model which has shaped the world as we know it is on its way. So, next time you here a politician talk about “full employment”, please just do look him/her straight in the eye.