Metric Monday: Fixed to Variable Cost Ratio

Context and Introduction to Metric

IT departments are increasingly pressured to drive innovation on top of their service provider responsibilities. There’s no one-size-fits-all approach to managing the business of IT, but some key financial metrics can help you find a balance.

Metric: Fixed to Variable Cost Ratio

The fixed to variable cost ratio helps you understand your cost structure relative to your strategy. Nearly two-thirds of most IT budgets are fixed cost. But a variable cost structure favors agility and flexibility. By maintaining a high proportion of your costs as variable, you can often cost-effectively scale up or down based on demand. Outsourcing and external service providers offer significant potential for lowering the fixed-to-variable cost ratio.

However, the benefits of agility and flexibility must be balanced against other factors. Many businesses have economies of scale or investment horizons that favor a higher degree of fixed investments (a higher fixed-to-variable ratio) to achieve lower service unit costs. In the long run, owning can be more cost-effective than renting. This analysis helps you understand how anticipated changes in your business are going to affect your total costs and budget demands.

For most IT organizations, this ratio is especially difficult to track without the right system in place. Most purchasing processes and general ledger systems do not tag expenses as either fixed or variable. This must be done separately by taking into account the true nature of your expenses.

Recommendations

Monitor your fixed-to-variable cost ratio to ensure it is in line with the needs of your business. With this ratio, lower is not always better. For some organizations, especially those with economies of scale, a higher proportion of fixed costs may be advantageous. Businesses that experience more significant organizational changes, especially reductions in staff, generally benefit from a higher proportion of variable costs. If adjustments are needed, work with procurement and finance to establish guidelines that encourage the right types of purchase contracts.

To read all 11 financial metrics you can use to run IT like a business, download the Financial Metrics Executive Brief. For more Metric Monday videos, visit Apptio’s YouTube channel.