Fixed Versus Variable Costs: Managing and Communicating the Mix

In these challenging economic times, business executives are increasingly focused on converting as many costs as is feasible from fixed to variable. IT leaders will gain credibility by becoming comfortable representing their costs in this manner and highlighting the tradeoffs inherent in fixed versus variable cost approaches. Clearly relating costs to value and risk as well as long-term implications, rather than simply fixating on near-term savings, will be the key to success.

META Trend: During 2002/03, as business organizations focus on strategic partnerships and customer needs, IT organizations will (re)evaluate ROI strategies. As IT/business collaboration matures, organizations will incorporate more balanced performance investment approaches. By 2004/05, scenario planning will form the basis of balanced value/innovation programs that manage dynamic technology investments and enable organizational agility. By 2006/07, 25 percent of Global 2000 firms will dynamically assemble, restructure, and dissolve virtual teams on demand.

Unfortunately, business executives do not want to hear that when business volumes lessen, technology costs do not decrease proportionally. This leads executives to try and make as many technology costs as possible variable during business downturns. As a result, IT executives must be prepared to address the following issues with business leaders in the near term:

• Which costs are fixed versus variable, and why?
• What variables affect costs, and how quickly?
• Which fixed costs can be made variable?
• What are the long-term implications of shifting from fixed to variable costs?

As the sectors of the world’s economy eventually shift back into a growth mode through 2005/06, leading IT executives will have positioned their organizations to shift the portfolio mix back toward a fixed-cost mindset. Longer term (2006-08), leading organizations will become much more adept at quickly shifting their portfolio mix between fixed and variable costs, as their business posture shifts between growth and contraction. At times, organizations will be able to achieve the “best of both worlds” by making costs variable or usage-based, with a cap or fixed-price ceiling. Eventually, best-practice organizations will identify triggers and actively monitor them to quickly shift the mix as needed, becoming true “sense and respond” organizations.

Which Costs Are Fixed Versus Variable, and Why?

Fixed IT costs generally are defined as long-term expenditures (over more than one year) to which an organization has committed. Typically, these costs include hardware depreciation/lease payments, capitalized development expenses, maintenance, long-term software licenses, and salaried personnel. Variable costs are generally defined as expenditures that change in the near term (over less than three months) based on changing business volumes, usage, or staffing levels. These costs typically include voice minutes, per-seat software licenses, contractor costs, travel expenses, training, and the incremental storage and server capacity required to support near-term growth.

What Variables Affect Costs, and How Quickly?

Best-practice IT executives not only have a breakdown of fixed versus variable costs readily available, they can also explain to business leaders what the key variables are and how quickly they change. For instance, voice minutes vary simply based on usage, and they are tracked weekly or monthly. Incremental hardware costs may be incurred as business volumes increase and additional transactions and growing data warehouses drive the need for hardware upgrades. Software costs usually depend on some combination of user count, processing power, and enterprise size. Mature organizations either have a capacity planning discipline in place to help predict hardware and software costs, or they identify triggers and track trends to help the business budget accordingly. Advanced organizations tie capacity planning to the broader disciplines of asset management and project planning, creating an overall asset management center of excellence, which focuses on managing asset life cycles.

Which Fixed Costs Can Be Made Variable?

In many cases, infrastructure costs that are normally fixed can be made variable through various vendor packaging and financing options. For several years, many server and storage vendors have offered to ship high-capacity systems, for which customers are charged only as they turn on incremental capacity. Similarly, some software vendors are willing to add incremental licenses as users are added, instead of forcing a company to buy in bulk upfront. However, software vendors typically are less willing to immediately reduce licenses when user counts are reduced, putting the onus on users to drive contract changes.

In recent years, many vendors (for example, hardware, software, networking) have been moving to “on-demand” options for technology products and services. The good news for users is that they only pay for what they use. Yet if usage increases, there is a significant chance that users will pay much more than if they had paid upfront or in bulk.

An extremely sensitive category of the fixed versus variable cost discussion is staffing. Normally, personnel are considered a fixed cost. However, organizations that are under extreme cost pressures turn to external contractors (often viewed as “virtual staff” that can be hired or laid-off on short notice) as a way to make the fixed cost of staffing more variable. This is certainly a way to make fixed costs variable, but shifting from staff to contractors has significant long-term implications when it comes to the skill sets and competencies that an organization has within its IT human resources portfolio, potentially undermining an organization’s ability to drive competitive advantage through its staff.

What Are the Long-Term Implications of Shifting From Fixed to

Variable Costs?

These human resources and on-demand examples highlight our most significant concern regarding shifting from fixed costs to variable costs: While working to save money in the near term, organizations potentially undermine long-term profitability and strategic positioning. Ideally, we recommend that users move to variable-based pricing with a cap or limit, which keeps in place the notion of IT costs going down as a percentage of revenues as revenues increase. Furthermore, users must focus on issues beyond cost, such as having the strategic IT skills that the business requires to differentiate itself in its markets.

Tracking, Representing, and Being Able to Adjust Fixed Versus Variable Costs Are Key to Credibility

All IT executives should be able to break down their costs into fixed and variable components. Effective organizations go to the next level and highlight the key variables, such as how quickly costs change, and the “levers” that can be used to adjust the mix. Best-practice IT leaders look beyond near-term cost savings and understand the implications of shifting the fixed versus variable mix according to long-term profitability and strategy.

Business Impact: IT leaders that reach best-practice levels by defining triggers to shift the mix of fixed versus variable costs while also clearly understanding and communicating key variables and how the variables can be controlled will enable the business to be much more financially flexible and responsive.

Bottom Line: Every IT leader should be able to discuss the basic breakdown of fixed versus variable costs, and categorize (i.e., delineate) these costs into underlying variables, expected time to change, and controls.