Outsourcing Turns Fixed Costs Into Variable Costs

Low monthly overhead could save your company during a cash crunch.

By Bob Reiss | November 3, 2010

This is the November column in Entrepreneur

A fixed cost is one that your business incurs whether or not it makes any sales. An example is rent: It has to be paid every month whether or not you’re generating any income, and it’s the same every month.

A variable cost, by contrast, is incurred only when you make a sale. A variable cost usually varies depending on the amount of the sale. A commissioned salesperson, for example, is a variable cost. If the rep is paid 10 percent of sales, and the sales for a given month are $25,000, then that person gets $2,500 in commissions. If sales drop to $1,000, then the commission drops to $100.

Converting fixed to variable costs is a major way to reduce your need for money. It could also be the difference between success or failure for young companies. Every fixed cost should be scrutinized for conversion to a variable cost.

Here are some examples of fixed costs that can be converted to variable:

Sales: Instead of hiring full-time salespeople and being burdened with weekly or monthly wages, go with independent sales representatives who work on a percentage basis. You pay none of their expenses. Reps don’t incur the burden of benefits, which can run as high as 30 percent of the salary of a full-time employee. Plus, ineffective reps are easier and less costly to replace than full-time salespeople.

The best reps have strong relationships with customers in their territory, which can translate to quick access and orders.

Manufacturing: You don’t have to own a factory just because you want to produce, assemble, store, ship and build your product. Contract manufacturers are happy to do all or some of the above for you. (Find them on search engines or the phone book.) They charge either for the space you take up or the functions you ask them to do. Most will work out a deal with you to charge a percentage of your billing, making this a variable expense.

Contract manufacturers also maintain insurance on your goods in their possession. They cover the cost of their employees’ benefits. This represents a huge saving in fixed and operating costs.

Yes, there are some downsides — including the fact that you may have to vie with their other customers for priority. Here persuasion and salesmanship are your best weapons. As soon as your volume warrants it, allocate a full-time person to cultivate the relationship with your “extended factory.” At some point, you may even want to position your employee on their premises for more control (and reduced risk).

You may have the type of product that would permit you to pay another manufacturer to make it for you under your brand. (This would be their “private label.”) Products like beer, liquor, drugs and computers are often made under this kind of arrangement.

Administration: Guess what? Your billing, sales reports, commission statements, royalty statements, inventory reports and aging reports can also be done on a percentage basis by your contract manufacturer (or a company specializing in doing all the administration for you). Of course, the more functions you outsource, the higher your percentage payment will be. But remember: everything you’re outsourcing is a function that you’re not hiring a salaried body to perform.

And it’s not just bodies, either. Why should you pay for the latest computers and software to run them? By outsourcing administrative tasks, you don’t have to pay the price of obsolescence, which can be very high in the world of computers. Your customers will have absolutely no idea that these functions are outsourced. (They probably wouldn’t care if they did know.) And your company takes on the aura of a well-established business from the outset.

Inventors/designers: You can get quality people to invent, develop and design products for you on a percentage of the products’ billing — in other words, on a variable expense basis.

Many will want to work on upfront fees only, a fixed expense. Salesmanship on your part can get them to charge your way. If they’re sold on your company, you personally, or the product, they’re more likely to comply with your wishes. Sometimes a compromise is required where you pay a modest upfront fee and a modest percentage on sales of the product.

Public relations: Some public relations firms charge on performance rather than the more typical fee basis. A performance-based agreement should be carefully spelled out, with specific accomplishments and their exact costs.

As your company grows and volume increases, there may come a time when the fixed cost is less expensive than a variable one. Before you switch, make sure you can maintain this high volume. Don’t switch on the basis of sales projections or a one-time uptick. As a general rule, investments in overhead should be made only when you have a high degree of certainty about the product, and when customer demand is strong and well understood.

Maximizing variable expenses reduces the amount of capital you’ll need to handle overhead and operating expenses in slow-selling periods. A low monthly fixed expense ensures that you’ll break even (and even profit) faster.

Bob Reiss is the author of Bootstrapping 101: Tips to Build Your Business with Limited Cash and Free Outside Help. He has been involved in 16 start-ups, is a three time INC 500 winner, a graduate of Columbia University and Harvard Business School and the subject of two Harvard case studies. He’s a frequent speaker at university entrepreneurial classes.