Given the fact that I didn’t go to business school (I wanted to be a writer before changing course to become an entrepreneur), I read a lot of business books. Specifically, I try read a lot of things that I hope will help me understand the nature of the ad agency I’m building, which is essentially a human capital company – what follows are some thoughts on why fixed vs. variable costs are a defining characteristic of ad agencies:
- Fixed costs are incurred even if revenue is zero, but variable costs kick in with revenue. This means that the structure of fixed costs vs. variable costs often become one of the most defining characteristics of a business. (This may seem obvious to other people, but I found it interesting to realize that fixed costs are the entire reason for “economies of scale,” as per-unit costs shrink as volume production increases, creating diminishing marginal cost.
- Take the example of Ford (cars) vs. WPP (advertising):
- A company like Ford can have billions in profits one year, and be near bankruptcy in another year, because it has huge fixed costs. This means that every new sale contributes to profit without simultaneously driving up costs, as the majority of costs are already incurred.
- Contrast the Ford Motor Company example above with the world’s largest ad agency, WPP, which has a much more variable cost structure. It will never make surging billion dollar profits in the same way, because every dollar of new revenue adds another $0.85 in costs, mostly due to the human capital. Furthermore, if revenue starts to fall significantly, staff are laid off due to the fact they are employed specifically for the purpose of servicing the revenue — which is why ad agencies go on hiring and firing sprees regularly.
- It is important to know two things, however: fixed costs are usually fixed within a relevant range. Rent is a fixed cost, but you’ll need more space as the company grows, so the fixed cost of rent with vary within a range. Another way to think of it is that all costs are variable to some extent. But the most important point is that variable costs go up and down as activity levels change.
- One of the takeaways for my business is this: I want to create a stable environment for my team by predicating growth on the revenue from accounts that makeup 1-3% of overall revenue, as well as leveraging the training site (WMT) to create efficiencies that should push margins 10-20% above industry-average. In this way, no abrupt revenue change should result in hirings/firings, as you see in other agencies.