Weird technical interview question
So I got asked this question that I have no idea how to think about.
Can you name a few companies in the high fixed cost business? what are some examples of high variable cost businesses? Is it possible that within the same industry one company can have a high fixed cost and the one will have a high variable cost? Which one is preferable? If revenue increases by 10x at each of these businesse, which of the two - high fc or high vc - will register the biggest increase in margin? Which business would you expect to have higher margins?
I was peeing in my pants
High fixed cost is a business with high capex to get off the ground - think most industrials businesses. High variable cost will be high SGA - as the business grows, costs scale with it (could be salaries). There can definitely be businesses in the same industry with high fixed/variable costs - think something like a dell or hardware company where there are high FC for building hardware. Then compare that to something like Netflix who has little in terms of physical products but high variable expenses in terms of personnel or movie rights.
Also, margin will be higher if revenue grows at a high fixed cost business. Say revenue is 100, fixed cost is 50, and variable cost is 10% of revenue (10). Revenue jumps to 1,000. Fixed cost is 50, variable is now 100. Margin is greater at the fixed cost company
To add to that, to the question "is it possible that within the same industry one company can have high fixed costs and that one will have high variable costs?". Yes, definitely. Imagine two beer companies. One can own its breweries and therefore has high fixed costs whereas the other can use other breweries' free capacity and make them brew it in exchange for a fee, resulting in higher variable costs. Same final product, two business models.
They are just asking you about the concept of operating leverage.
Think of it this way. If you have financial leverage, your upside and downside is more pronounced.
Same if you have high operating leverage. Your upside from growth is going to be great if you can grow the business but you are going to get really hurt from a bad year (in terms of margins) if you can't control your cost (same with interest payment... you can't control/reduce that).
Not weird. Had encountered similar questions to this. But agree you could be caught off guard by this type of question.
Best to simplify it.
Imagine two very similar businesses that employs tutors that provide private music lessons.
Both charge the same per lesson, do the same number of lessons per week and have the same number of tutors employed but firm 1 pays the tutors a fixed weekly salary (high fixed cost) and firm 2 pays their tutors an amount for each lesson they do (i.e. high variable cost).
As the number of students/lessons goes down firm 1 is in trouble because it has to pay a fixed agreed salary to it's tutors. Firm 2 is ok because less lessons, it pays it's tutors less. On the flip side, if the number of students explodes, firm 1 is happy because salary is fixed and it gets more of the profit (essentially it's fixed cost is being spread over a larger number of students) but firm 2 must pay more as it's tutors are paid per lesson (variable cost).
You could do an example out in excel with actual numbers to get the concept clear. It is a tricky little question and easy to trip you up if you have not thought about it before.
PS some people here seem to confusing capex with fixed costs. Fixed costs are expenses that hit the P&L and impact income, capex does not. Although granted a high capex firm will often have higher fixed costs but not necessarily.
PPS as an interesting aside you may be rightly thinking that as the number of student goes up, the tutors at firm 1 will be doing more lessons for the same pay....you might also have realised that they probably won't be very happy with this and will eventually want a pay rise...this illustrates another important point that in the long run fixed costs can often be variable in nature. Bust that one out in the interview and the accounting nerds on the other side of the table will be nursing a chubby for the duration.
As other users have said avobe, those questions were about operating leverage.
An example of high fixed costs industry: Oil & Gas exploration. High variable costs: SaaS
So your title says Associate Manager; for which position was the interview for?
Company A: revenue of 100, variable costs are 70% of revenue, so 70 in this case, and fixed costs of 20. Operating profit would be 10 (100-70-20=10). Operating margin would be 10% (10/100). If sales rise 10% to 110, variable costs rise to 77 and fixed costs remain 20 so operating profit is now 13 and the operating margin is now 12%.
Company B: revenue of 100, variable costs are 10% of revenue, so 10 in this case, and fixed costs of 80. Operating profit would be 10 (100-10-80=10). Operating margin would be 10% (10/100). If sales rise 10% to 110, variable costs rise to 11 and fixed costs remain 80 so operating profit is now 19 and the operating margin is now 17%.
Typically high fixed-cost companies have large PP&E which requires annual depreciation expenditure that is not linked to revenue. Industries like airlines and auto manufacturing are great examples of this. You generally want to buy companies with high operating leverage coming out of a recession as earnings and cash flows tend to expand must faster than companies with low fixed costs. The opposite holds true when we are entering a recession or slow down.
To simplify further, imagine company A pays employees a FIXED salary and company B pays employees based on their performance (the salary varies / is VARIABLE). If revenue increases by 10x, the COST of Company B employees would go up with it. Meanwhile, margins would go through the roof at Company A.
The downside is that having fixed costs can be brutal if business isn't performing. If revenue falls 50% at Company B, so did my costs!
Obviously it's not that simple in the real world where company A employees would get pissed once they found out how much $$ you were making, and they wouldn't be incentivized to work as hard, etc.. while employees as company B would just leave and find another job if the going got tough.
Is retail a high fixed cost biz or high vc cost? Both departmental stores and apparel?
B&M retail is high fixed costs due to leases, which is why they have metrics like same store sales.
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