In this post, we are going to discuss a few concepts that are not part of standard financial reporting (IFRS/IAS) and hence not readily available in annual reports or investor presentations. These concepts are essentially from the management accounting discipline and they can be quite useful in understanding the firm's cost structure, which the standard P&L/income statement does not reveal.
Fixed costs and variable costs
Variable costs are those which are directly correlated with the units produced/sold by the firm. Variable costs include direct material, labor, and factory overheads such as power and fuel, sub-contracting or job work expenses, etc. Higher the output higher these variable costs. In contrast, some costs are less correlated with the output generated by the firm such as office rent, depreciation or salary paid to corporate office employees, etc. These are called fixed costs or semi variable costs. Though fixed costs do not change with a marginal increase in output, they do increase if a firm undertakes capacity expansion through building another factory or an office building. Thus fixed costs increase in a staggered manner.
Just like debt levers the balance sheet, fixed costs levers the P&L. Operating leverage thus can be explained by the quantum of fixed costs assumed by the firm. Higher the operating leverage, higher the contribution of revenue to profit beyond break-even point. That said, operating leverage means the cost structure is risky. In good times, operating leverage can benefit a lot but in downturns profitability can plummet and the risk of loss increases manifold since the firm has to pay fixed expenses regardless of any revenue.
Contribution margin and breakeven sales
Contribution is a management accounting equivalent of gross profit. Contribution is what you get after deducting the variable cost from revenue. Further reducing fixed costs from contribution gives us the profits generated by the firm. The utility of contribution margin is in finding the breakeven sales. By dividing the fixed costs with the contribution margin, we get the breakeven point of sales. It’s the level of sales where the firm will end up in a no profit no loss situation and every sales generated beyond this point will start contributing to profit. This analysis is widely used for internal managerial decision making and is generally useful in assessing safety margin in revenue. Safety margin is simply the current excess revenue the firm is making beyond break-even point.
It’s noteworthy that correctly identifying variable and fixed costs for this analysis is important. It can reveal a lot about the cost structure of the firm and thereby gives insights into the nature of the business.
To illustrate this, we will evaluate a different scenario with different parameters.
Scenario 1: High variable and high fixed costs
High variable costs imply a thin contribution margin. Now, it is subjective but less than 20% contribution margin can be safely considered as low. Thin contribution margin reflects lower value addition and hence the firm needs to generate higher revenues in order to generate enough contribution to cover the fixed costs. In other words, breakeven point of sales is higher and thus safety margin is lower. The businesses which demonstrate this type of cost structure are usually manufacturing enterprises with commodity product offering. These types of businesses are most susceptible to increased input cost or sudden downturn in revenues.
Scenario 2: High variable and low fixed costs
In this cost structure, the contribution margin is lower but fixed costs are lower too. Hence, breakeven sales will not be as high as we would get in previous cost structure. If revenue declines, profitability will get affected but the firm will not start losing money as rapidly. Nonetheless, the firm needs to generate higher revenues in order to generate decent profitability. Trading and certain type of manufacturing businesses exhibit this type of cost structure.
Scenario 3: Low variable and high fixed costs
Low variable costs mean that the contribution margin is higher. However, fixed costs are higher as well. This means that value addition is moderate to high and breakeven sales is comparatively lower. These firms have more cushion in terms of breakeven but given high operating leverage, profits are driven by topline. This cost structure is exhibited by more value-adding businesses in the chemicals, pharma, auto-components, and capital equipment sectors. This type of structure is more favorable than the one described in Scenario 1 as fixed costs can still be managed through cost optimization initiatives but variable costs are difficult to control in general. Nevertheless, these businesses lose a lot of money very fast in absence of substantial revenue.
Scenario 4: Low variable and low fixed costs
The best of both worlds is the cost structure where the contribution margin is higher along with lower fixed costs. These businesses offer best unit economics out of all scenarios. The value addition in these businesses is often driven by intangible factors such as brands, intellectual capital, R&D capabilities etc. FMCG, specialty pharma, IT businesses usually have this type of cost structure. Safety margin in terms of breakeven sales is the highest in this scenario. Profitability increases dramatically when the revenues grow though it remains resilient to downturns in revenue.