Monday, November 17, 2008

Recession and the importance of fixed costs

One thing that I have not seen much discussed in current discussions on the economy is the importance of fixed costs at a time of economic downturn. By fixed costs I simply mean all those things that the firm must keep paying including financing costs. This is a critical issue, especially for smaller businesses that have often entered into arrangements such as leases on cars in part for taxation reasons.

The maths are simple enough. Say that you have sales or fees of 100, a profit of 10, fixed costs of 80, variable costs of of 10. Sales drop by 20 per cent to 80. Now your costs are fixed 80, variable 8, leading to a loss of 8.

There is nothing magical in these numbers. However, they do illustrate one of the key factors explaining the severity of some downturns.

With time, fixed costs become variable. However, in severe downturns firms do not have this adjustment time and can be forced to close as cash runs out. The higher the fixed cost ratio, the sharper the downturn, the more firms are forced to close, adding to downward pressures.

Those firms with better margins or greater net assets survive because they have the time to adjust. However, their action in cutting costs create second round downwards pressures, extending the downturn.

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