The first is Dell, whose inventory turns are 101, which means they have three days of inventory on hand at any given time. Their business model is innovatively designed so that when you order a computer and pay for it, they don’t own the parts yet. They bring in the parts, build, test and ship the computer all before they pay their suppliers, so they have negative cash on hand. This business model reduces the risk of inventory management. If their plant burns down, they’ll lose tables and shelves, but never more than three days of inventory.
Rolls Royce makes jet aircraft engines in addition to cars, and they also provide maintenance for these jet engines. Customers don’t enjoy buying engine maintenance; they prefer to buy “flying time.” Rolls Royce has structured their business model so that they sell actual operating time of their engines, and in this way they mitigate the customer’s risk.
Caterpillar tractor does the same thing by selling “earth moving,” not equipment. In this case the business model is based on charging the customer for the yards of dirt moved. By focusing on what value your business really provides, i.e. flying time instead of engine maintenance, and selling that value to the customer, you can remove their worries about risk.
If you talk to your local cost accountant, they will tell you that labor costs (along with materials and supplies) are recorded as variable costs. In reality, they should be treated as fixed costs. Why is that? Because, in the short run, it is not easy to turn this asset into costs that can vary with revenue which is the definition of a variable cost. It is very difficult to lay off people in a low revenue month and then rehire them in a high revenue month. If you try to do that, hiring costs, training costs and cost of quality all increase usually to the degree that they more than offset keeping the people through the downturn.
Many companies will try to furlough people or send them home early in an attempt to turn this fixed cost into a variable cost. While this works in the short run, people will get tired of the lower income and unpredictable work schedule and eventually will look for a new job. This again raises the cost of hiring, training, etc.
The only true variable labor cost is the use of temps and overtime. If your company is in a volatile market, it is best to plan for a level of temps and overtime to create a variable environment.
I am helping to evaluate a possible acquisition candidate from an Operations perspective for a client. As part of my evaluation, I run historical financials through a model I have developed to determine things like: 1) what is the labor productivity and is it getting better or worse? and, 2) are fixed costs really fixed? One of the measures I look at is breakeven which is developed by comparing direct variable costs to fixed overhead costs. This company’s revenue is at less than half of break even and has been so for a long time! I suppose that could be why they are interested in selling, but as I discuss issues with them, I get the sense that they don’t know how bad it is. How can that be?
As part of the financial reporting, key performance measures and budgeting processes, companies should keep a close eye on the breakeven point. Developing a deep understanding of the elements that impact it can help to steer the company to success.