Fixed & Variable Costs: Adding Flexibility to your Business Model

In Economics, there are two basic types of costs (or expenses) associated with running a business: Fixed and Variable.

Fixed costs are those that do not change with the level of business, while variable costs fluctuate with the level of business.

For instance, in a brick-and-mortar retail store, rent is a fixed cost. This is true even if rent increases by 5% per month. It is a fixed cost because, assuming everything else is the same, it won’t change depending on whether that store sells 5 widgets or 500.

In the same retail store, the costs of the widgets are a variable cost. This is so because if the store buys 5 widgets, it will spend less money than if it buys 500. So, if business is good, and the store can sell 500 widgets, it will see its costs increase accordingly.

Why is an understanding of these costs, especially variable costs, important?

Because a business model that has a higher proportion of variable costs is more flexible in a downturn. The retail store can’t cut its rent, but it can cut the number of widgets it buys. So variable costs act as cushions during recessions.

This is also important because variable costs can be indirect, and can be difficult to calculate, and thus can actually end up overtaking the revenue associated with the increase in business and lead to losses.

For instance, the profit margin on widgets might be so slim that it would take 200 widgets a month to cover the costs associated with an employee. But, it may be necessary to hire an employee for every extra 100 widgets sold in a month.

The costs associated with the extra employee may be in the form of taxes, insurance, time, etc. and may not be obvious; whereas the extra revenue from the extra widgets sold is obvious and easily calculable. So, the retail store may find itself with excellent, and growing, revenues, but still forced to close its doors.

Such a business model is broken, but not necessarily irreparably: If widgets operate in an “Economy of Scale,” then at a certain point, the expansion pays off. “Economies of Scale” are situations where ordering more of something decreases the per-unit cost of that something. For instance, ordering 50 widgets may cost $50, but ordering 100 widgets may only cost $90. The purchase order on the 100 widgets is more, but it’s 10% cheaper on a per-widget basis, which is how the retail store sells its widgets.

It is obvious how this affects variable costs: at 10% more profit per-widget, the store only needs to sell 180 widgets per month to cover the costs of the extra employee.

In other words, the retail store will lose money and not be a viable business until it is able to exploit the “Economy of Scale” on widgets and get its per-unit variable cost in line with its per-employee variable costs.

Invariably yours,
Aaron

Value and Money 2: Potential Value

In a previous article, I made the case that “value” comes from the transformation of resources. But that is not the complete source of value. There are actually two sources of value:
1) transformation over time, or “past” value, and
2) potential transformation in the future. We won't call this “future value” because that term is already taken (you can calculate the future value of $100 earning 10% interest, compounded annually, using the formula Fv=Pv*(1 + r)^n → 100*(1+0.1)^n, where n is the number of years.) So, instead of calling this future value, let's call this, “potential.”

This “potential” value is where opportunity exists. It is easy to calculate past value, or how much transformation and resources have gone into something. But it is difficult to calculate how much that something will be worth in the future (i.e. with additional transformation).

Potential value is a measure of the probability of transforming something with value into something with different value.

Let's return to our Smidget Widget example. Bob buys consumables and transforms them into widgets. He knows that if he sells widgets in bulk, people will buy them and he will make a profit. You suspect that widgets can be sold individually in a certain location for a mark-up. If you are right, then those widgets have more value to you than to Bob because you have spotted a potential opportunity.

In this case, you are putting forth additional transformation to the widget: you are taking bulk widgets, transforming the bulk widgets into individual widgets, and targeting a specific market. So, those widgets have potential value to you, and the price you are willing to pay for Bob's widgets is based on a calculation of how likely it is that you will capitalize on that potential.

Now that we understand that all value comes from transformation put into it and potential transformation in the future, it becomes clear that the source of all business opportunity is actually a form of arbitrage – taking advantage of value differentials in the marketplace.

Opportunistically yours,
Aaron

Basic Forms of Marketing in an SEO Wrapper

Tony at SoCalCTO has an interesting post regarding SEOs for startups:

http://socalcto.blogspot.com/2009/11/seo-for-startups.html

There, he explores the value of Search Engine Optimization for startups, and the difference between on-page and off-page SEO.

But what form of marketing is SEO?

There are three basic styles of marketing:

1) You make and sell widgets (which you call "Smidget Widgets") and post all over the place that you make and sell widgets, hoping that people who want widgets will see your message and be persuaded to buy your widgets over your competitor's.  An example of this is a billboard or TV advertisement.  I call this the "shotgun" approach.

2)  You make and sell widgets and target your advertising to people that you know are already looking for your widget.  An example of this is sending out a targeted mailing list to people that you know have a high likelihood of purchasing your widgets or purchasing ads in a magazine which you know your target demographic reads.  I call this the "surgical" approach.

3) You make and sell widgets.  You target your message to people who need widgets but don't know that they need widgets.  They may not even know that widgets exist.  Perhaps you advertise where a complementary business advertises, or open in-sight of a complementary business ala Starbucks and Noah’s Bagels.  I call this the "blue ocean" approach (named after the Kim and Mauborgne business strategy, although I’m not using the term quite as it is intended).

Most SEO falls into the shotgun approach, although most people believe it is surgical.  Generally, you will pick a search term (such as "widget") and try to become the first website to show up on a Google search for “widget.”  But, in this scenario, people doing the search already know that they want information about widgets.  So, you're not getting a new market, you're fighting with your competitors over consumers that are already there.  This means that your widget had better be cheaper or better.

But, you know that you will be the #1 search for Smidget Widgets (because you've talked with an attorney about creating and protecting a trademark, right?).  So, you know that people searching for Smidget Widget are already interested in your product.  In this case, there is a lot less competition, and as a result, a higher conversion rate.  You are, in effect, creating a new market, or a sub-market.  You are moving away from the "widget" market and into the "smidget widget" market.  Of course, those potential customers must already have heard of "smidget widgets," and those initial leads can come from a variety of sources.

In this case, the best thing you can do is make sure that your widget is reviewed by industry websites and that your customers provide reviews and write about your widget on their site as well.  This is a different kind of search engine "optimization," and one that is more valuable.  It will also lead to more "off-site SEO" and help provide "link-juice."

The basic takeaway of this is that the goal of “shotgun” advertising, and most SEO, is to capture more eyes with the hopes that a small percentage of those leads will convert into sales.  Surgical advertising aims at a higher percentage of conversions, and blue ocean advertising should be higher still.

This concept is a mix between “brand positioning” and “value added business strategy.”  Both of those concepts will be explored further in the future.

Blue Oceans Ahoy!

--Aaron

Problem Solving Step-by-Step

At its heart, Holocognics is about planning. The only way to plan effectively is to understand something thoroughly. Below is the Holocognical Problem Solving Technique. This can be applied to any problem, including political decisions. The point of laying this out is so that you don't miss something and are able to come to the best decision.

i.Identify problem.
ii.Is it a problem?
iii.Is it something that can be solved through human effort?
iv.Identify all possible solutions.
v.Will any of those solutions “solve” the problem? Re-ask whether it can be solved through human effort.
vi.Is the solution “better”? What are the costs of the solution? What are the new problems created by implementation of that solution? Do those new problems outweigh the benefit of fixing the original problem?
vii.Pick the best solution.

Step (vi) should be performed for each solution identified in step (iv).

Seems obvious right? But most people skip a step, and that can cause problems. Let's look at this technique in action:

Let's say your business is growing and you have an opportunity to take on a new account. The new account will bring in $100,000 in revenues annually. But, you cannot take on that account without hiring a new employee. Many people will just hire the new employee and take the new account. But, that can cause a lot of problems, as we'll see.

I.identify problem – you need to hire a new employee in order to take on the new account.
II.Is this a problem – depending on your goals for your business, this may not be a problem. Perhaps you are happy with the size of your business now, and don't want the extra account. Perhaps you can grow more slowly without needing to take on the extra employee. It just depends on the situation. Let's assume that you really want the account, and so you need to hire the new employee.
III.Is it something that can be solved through human effort – In this case, we're assuming that by hiring the new employee, you will be able to accommodate the new account. In some cases, that won't be possible.
IV.Identify all possible solutions – can you outsource this work? Can you mechanize the work? You want to identify ALL possible solutions, even those that you will eventually dismiss.
V.Will any of those solutions “solve” the problem – Let's assume that you can't mechanize this particular employee's role. But there's a possibility that outsourcing will work.
VI.Is the solution better – Hiring an employee means paying worker's comp, employment taxes, and managing the employee. This means you will be devoting time and energy to the new employee, especially in the beginning. This time and energy is money spent. Maybe the only employee available that can competently handle this work requires $80,000 annually. So after worker's comp, taxes, etc. you're not actually making a profit on that account. But, maybe the account has potential to double in a few years. The employee's salary won't double in that time. On the other hand, if you outsource, the salary is lower, but you have less control over the quality of work.
VII.Pick the best solution

The most important thing is that you identify ALL possible solutions and thoroughly explore whether they actually benefit you.

In the above example, it is absolutely possible that by taking the $100,000 account, you end up in a worse position than you were in before. There are also problems that may not have a solution that works.

--Aaron

A Primer on the Southern California Tech Community

Some of you may have noticed the badge on the right side that says "Southern California Tech Central: Featured" and wonder what that is.  Well, I'll tell you:

It is THE resource for tech-industry information in So-Cal.  The domain is http://cc.tcosc.org/

When you visit the website, you will be presented with all of the latest news and analysis from a variety of tech professionals (including me).  Even if you are not located in Southern California, this is a terrific source of information and it is organized very well.  Over the past few years, So-Cal has become a major hub of the tech industry, and Tech Central is the online nexus of that hub.

Tech Central is co-sponsored by the Technology Council of Southern California and TechEmpower.

TechEmpower is a tech-development firm, and the leading eLearning development company.  Its founder/CEO is Dr. Tony Karrer who maintains the blog SoCal CTO.  Tony's blog has a wealth of information, especially for those interested in learning how to utilize sites such as LinkedIn, Facebook, and Twitter for more than just ending up on marketer's spam lists.

--Aaron

Second Review: Of Two Minds by Charles Hugh Smith.

I have been reading Of Two Minds (OTM)--http://www.oftwominds.com/blog.html-- for almost as long as I have been reading Calculated Risk. Mr. Smith has coined the term “Wessay” as in “Web-essay.”

Mr. Smith has a number of works of fiction that have been published, which I haven't read. But his writing style is fluid and easy to follow, so one day I may give one (or a few) of his books a shot.

His blog is more analysis-focused, with frequent, (about once a day) lengthy posts.

Topics vary greatly, but generally include topics such as housing, stock, sustainability, income disparity, peak oil, and global warming.

OTM often has contributions by readers. Mr. Smith's readers are a very bright bunch and will send their own analysis which Mr. Smith incorporates into his own writings. This provides lots of different perspectives on a topic.

My favorite part about OTM is Mr. Smith's pragmatic take on life: if you live close to work, why not ride your bike there? You save money and stay healthy, which saves you more money.

He was one of the many bloggers who saw the housing and financial collapse coming from a mile away. For example, in 2005 he wrote:
“The wild card no one planned on is the U.S. housing bubble and the consequences of its collapse. That bubble is stiil inflating, ensuring the "pop" will be more devastating than anyone expects; housing starts are still rising, building a classic over-supply where there's far more houses on the market than buyers. As builders drop prices in a desperate bid to dump inventory, they will lower prices not just of new houses but existing housing as well. Not a pretty dynamic, but it's the one which always plays out in housing booms and busts. “

A Rickety Global House of Cards (October 20, 2005) (http://www.oftwominds.com/blogs/house-of-cards.html)

This was not some wild guess either. This was based on detailed and reasoned analysis. Indeed, Mr. Smith was a practitioner of the Holocognical arts while I was still a law student.

Other information about OTM:
The colors are fine, the layout is ok. There are LOTS of words. This is great if you enjoy reading (like I do), it's even better since the content is good. But the blog can be hard to navigate. Overall, I highly recommend giving OTM a read. If you enjoy my blog, you will enjoy that one as well.

Critically yours,
Aaron

Value and Money

Value and money. Two things that business can't exist without (especially if you define business as an undertaking for value).

Value is the last major stone of our foundation, and an essential concept.

Money is, obviously, valuable. So are lots of things: gold, platinum, cars. Those all have value, usually quantified by money. But those are quantities of value in their own right. You can trade gold for platinum, or platinum for cars. Once again we are left with the question: if all of those things are quantities of value, what exactly does that mean?

To answer this, we will look for the common denominator in all things of value. If gold, platinum, cars, and money all are quantities of value, then if we find the common element in all of those, we will have isolated value. Before we begin, we need a wider sample set of things that are valuable. So let's use the following categories:

Naturally occurring items such as gold, wood, and oil.

Money/currency – man made items that act as a “store of value”

Consumables such as cars and tools – these are man made items that people want to own, whose value is measured roughly in proportion with their cost to make

Art -- man made items which are not consumed, and which have value well exceeding their cost

These are very rough definitions, and have plenty of cross-over. There are items which are not on the list, which perhaps should be. I know. I could go into a lot more detail, but it would turn into a Master's thesis. What we've covered so far is enough for this thought experiment.

What creates value?

Naturally occurring items – Oil, wood, gold, etc. have their "value" measured in U.S. Dollars, and that value changes constantly. What we're interested in are the different elements or factors that create that value. The best approach is to go in reverse.

The end result of natural items, for example gold, is the nugget. We're not going to talk about the bracelet (that would fit under "consumable"). The nugget is mined by people. People have to put in labor, which is really time. They use picks and machines (consumables). To put in labor, they have to eat food and drink (more consumables). If you think about it, natural items get their value from the effort of removing them from the ground. We will call this a “transformation.” We are transforming the tree into lumber, the gold vein into a gold nugget, the oil field into barrels of oil.

Consumables – Consumables are made with labor and more consumables and money. What is the ultimate source of the tools to make the cars? Labor and money. The resources (gold, oil, etc.) have to be transformed into the tools (consumables). The source of transformation is labor (time) and money. So consumables = time and money and resources. This is also a transformation. We are transforming the resources into the consumables by applying time, labor, and money.

Art – Art is made almost exclusively with labor and time. The artist has to live by eating (consumables), and needs paintbrushes, paint, etc. (consumables, resources), but the major contribution is labor and time. Art derives its value almost exclusively from the transformation of consumables into something else.

Money – Lastly money earns its value from the stability of the country backing it. That stability is because of the time put in to build the country. Money is the grease that allows the transformations above to happen. Money derives its value by allowing one person to transform their resources, consumables, or art into another. For instance, if Bob transforms resources into a car but wants art, he can transform the car into money by selling it, and then transform the money into art by buying the latter.

So, if you look at everything, and trace them back to their root source of value, we see that transformation is ultimately the source of value. It is the transformation of resources into consumables that people want that creates the value of the consumable, it is the transformation of consumables into art that creates the value of the art, and it is the ease and predictability of transformation that creates value for money.

Understanding that the ultimate source of value is transformation, and ultimately the transformation of resources over time, changes the way we look at things.