The Importance of Cost Variability in Small Business – Direct Cost

by Adina Luca, February 27, 2020

Here is a scenario: your last year revenues were 12% less than projected and expenses were 7% less than expected too. Good. You managed to save some margin, no matter how small. However, if this trend continues – revenue going down faster than expenses – you will run into trouble. You need to change something. But what could you do?

Purpose of Costs

Let’s look at it differently. There are two types of expenses in your business that serve two different purposes: Direct costs and Indirect costs.

Direct costs are the costs that you incur because you are making and delivering your particular service or product. Think labour cost, materials that go into the service or product, including packaging and transport, and sales bonus if you pay any. The type of Direct costs you have is a consequence of the type of revenue: you hired a particularly skilled employee because of the nature of your product or service. You have (or don’t have) transport or delivery costs because of the way you structured your product or service delivery.

Indirect costs are the costs that you pay for in order to maintain the infrastructure of your business, irrespective of what you sell. We will come back to these costs separately.

Variability of Costs

Let’s start with an example. Assume you are looking at the following end of year result:

Year:                  Year1   Year2   Year3   Year4

Revenue:           100       120       110       140

Direct costs:      (40)      (60)      (60)      (75)

Indirect costs:   (40)      (50)      (50)      (60)

Profit                  20         10         0           5

So, what does it mean? You are back in profit, after a slow year. Time to open that champagne!

Wait. Before you get happy bubbly, open a spreadsheet first. Put down the above numbers and insert a row to calculate the percentage of Direct costs out of Revenue. You will now see this:

Year:                  Year1   Year2   Year3   Year4

Revenue:           100       120       110       140

Direct costs:      (40)      (60)      (60)      (75)

% of direct:       40%      50%      55%      54%

The increase in percentage of Direct costs out of Revenue tells you that your delivery costs are not under control – they stay high when revenue is lower in Year3 and they go up in percentageThey are not variable enough as they increase rather than decrease to adjust to slower years.

There are a number of possible causes – here are some questions to identify them:

  • Do you have fixed delivery costs and no performance-related pay?
  • Have you started selling to lower margin clients and, although you were busy delivering like before, you made less money?
  • When your revenue goes up unexpectedly, do you rush into hiring more workforce, who need time to adjust?

Have you accounted for the owner’s delivery cost?

What if the owner works along with the staff? Do you calculate a percentage of drawings as a ‘Direct cost’ at a reasonable rate? What we find is that entrepreneurs discount their own delivery work and that affects how they calculate the Direct cost and consequently the pricing they quote to clients. Most of the time, the entrepreneurs’ hourly rate is higher than the rest of the staff – adding the owner(s)’ rate into the Direct cost may change the picture dramatically. What was previously considered a profitable year from an accounting point of view may only be a good year to cover all costs.

You want the percentage of Direct costs to stay constant

In an ideal world, when Revenue goes down, your Direct costs should follow. The variability of your costs i.e. their increase/decrease in direct proportion to the revenue, is crucial in ensuring profit. In other words, the percentage of Direct costs out of revenue should be close to constant. Direct costs variability is a measure of efficiency in delivery.

To illustrate with numbers, here is what happens when the percentage of Direct cost stays constant – you still maintain some small profit when revenue goes down in Year6:

Year:                  Year1   Year2   Year3   Year4   Year5   Year6   

Revenue:           100       120       110       140       160       140

Direct costs:      (40)      (60)      (60)      (75)      (86)      (76)

% direct costs   40%      50%      55%      54%      54%      54%      

Indirect costs:   (40)      (50)      (50)      (60)      (60)      (60)

Profit                  20         10         0           0           5           4

% profit              20%      8,3%     0%        5%        3,8%     3%

How to keep a constant percentage of Direct cost – the order of action:

  1. Find out what sells at a higher margin and who buys that and build a strategy to continue selling more of those. We always start by trying to maximise the incoming. Regular analysis of your profitability per project/client is cumbersome, but very important. Trying to replicate the previous good results is easier and more efficient from the selling effort point of view – we believe in the path of least resistance, which is doing more of what already works well.
  2. Measure the efficiency of your workforce and make sure you account for all delivery effort – including the owner’s. Keep on asking yourself ‘would my product/service delivery be the same if I did not have this cost?’ in order to identify all Direct costs. For example, in some industries, the post-sales customer service is a Direct cost, whether or not it is charged to clients. It may be overlooked as an infrastructure cost, but it has a direct impact on your service if advertised as such. You should account for it in your profitability. Timesheets, product orders or conversion rates are collected in the operational data daily – these are valuable sources of information that can help you understand your workforce efficiency and whether you are selling profitably. Gather that data, analyse it and use it in your decision making to improve efficiency.
  3.  Outsource with reason. In theory, it is more profitable to outsource all your delivery. It increases the variability of your Direct costs, which will help you if things don’t go as planned. In practice, it is reasonable to outsource either the non-core or highly specialised aspects of your projects. Note to the fundamentalist uberisers out there – do not outsource all your delivery in the name of flexibility. You may be throwing the baby out with the bathwater. A stable workforce ensures a stable business. There is a lot to say about the convergence of goodwill that happens when you build a team around your business versus always relying on ad-hoc help as projects come in.

Most of the time, it is enough just to know where variability lies and what percentage each type of cost represents to get you going to maintain those percentages and match variations in revenue.  However, if you would rather open the champagne than open a spreadsheet to check the variability of your costs, let us do it for you.