Popular Vietnamese tuckshop business, MissChu, was placed into voluntary administration late in 2014.
KordaMentha Restructuring, the appointed administrator, is reported to have attributed the distress, in part, to the lack of controls over fixed costs in the business. What lessons can we draw for our own small businesses?
Fixed Costs is the term used to describe a cost that does not increase or decrease in amount when the level of goods or services produced/sold by the business increases or decreases. For example, a retailer must pay rent, utilities, insurance and salaries regardless of the number of sales. Fixed costs (also known as overheads) tend to be time-related such as rents paid monthly over the life of a commercial property lease; they must be incurred for the business to operate on a daily basis.
This is in contrast to Variable Costs, which are volume related and are paid per quantity produced or sold by the business. They typically include any costs that may be varied or stopped at short notice in response to changing activity levels in the business. Examples include the direct cost of raw materials used to make a product, credit card fees on purchases made by customers and the freight costs to deliver a product that has been sold.
Here are three examples of fixed cost errors made by rookies:
- The Table Tennis Table. Often coming from genuine good intentions to provide a fun and motivational working environment for your team, this seemingly inexpensive employee perk can have significant hidden fixed costs. A table tennis table and equipment may set you back $350. However the rental for the floor space, based on standard commercial rental in Sydney’s St Leonards and allowing enough room for the table and surrounds, would be $500 per square metre p.a. equating to a total of $10,000 per year for each year of a standard 3 year lease. This fixed cost cannot be varied in response to changing sales volumes or market conditions nor readily reassigned to an alternative revenue generating function. It is important to understand the true cost of providing such employee perks and be confident that the business can comfortably carry the fixed cost of the floor space for the duration of the commercial lease.
- Which Comes First: The Revenue Or The Costs. Seasoned business owners will more likely lean toward the view that revenue comes first when it comes to fixed costs. Again using commercial property rental as an example: Assuming your business plan forecasts the business to grow from two to five employees in three years, you may be tempted to lease an office with enough space to accommodate five people. Carefully consider the impact of this fixed cost decision. It may be prudent to first ensure that revenue is growing in line with the forecast. This may mean a tight squeeze for staff in the last 6 – 12 months of the 3 year lease and some creative hot-desking options … but better to be squeezy than out of business due to insufficient revenue growth to cover the overhead costs of running the business.
- Underutilising A Fixed Overhead. A long established cafe in North Sydney closed just before Christmas. The rent was $11,000 per month and the cafe was open for breakfast and lunch on weekdays (closing at 3pm each day). Assuming the margin on a cup of coffee is $3, the café would have needed to sell 183 coffees between 7am and 3pm every day just to break even on the rent. A number of Sydney inner city cafes have looked for creative ways to leverage fixed costs and have come up with a rent sharing arrangement: one business uses the premises to operate a café during the day and a separate business uses the premises for a restaurant in the evenings and on weekends. The fixed rental cost is leveraged over two businesses with two different target markets while making use of the full capacity, day and night, 7 days per week.
The key messages when considering signing up to fixed overheads are to get an external opinion, speak to people in a similar sized business, prepare a budget, be realistic, and be innovative.