Monday, August 15, 2005

Fixed cost vs Variable cost structures..

Is it fair to say that an industry with a high fixed cost structure is more cyclical than one which isn't?

If most of the costs in the industry are fixed and are up-front - say construction of a plant - variable (marginal) costs would be low. There is almost always a give-take relationship between variable and fixed costs - businesses with high fixed costs invariably have low variable costs and vice-versa.

If an industry characterized with high fixed costs faces a downturn, companies would be willing to lower prices to the marginal cost of production as it would still cover part of their fixed costs. As marginal costs would be very low in this industry, pricing could indeed take a nosedive. During an upturn however i.e when demand firms up, prices would rise, and as marginal costs are very low, almost everything would fall straight to the bottomline.

A substainable business is one where ROE > cost of equity. This can happen if either of the following three hold:
a) Either/or low fixed costs and variable costs, so that EBITDA and/or FCF margins are high
b) High asset turns - Wal-Mart has 3-4% operating margins but still survives because of high asset turns.
c) Financial leverage.

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Interesting.

See a nice article by Telser (Telser, Lester G. "The Usefulness of Core Theory in Economics." The Journal of Economic Perspectives, 1994, 8(2), pp. 151-64) for some speculation about fixed, variable, and avoidable costs. He basically says that the airline industry may not have an equilibrium, due to the structure of costs.

Nice post!

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