How to Stay Flexible When the Market Changes
Because not all costs shrink when your sales do
A company producing pencils is growing significantly. For each pencil it produces, it needs more wood and graphite. If the company wants to produce more, it buys more wood and graphite. If it wants to produce less, it buys less. These costs are called variable costs. They can be adjusted flexibly, depending on how much is needed.
This aspect is especially important in a downturn when people buy fewer pencils. The company can reduce its costs simply by buying less wood and graphite. Unless it has a large stockpile of these materials, it can react immediately to changes in demand.
This flexibility is crucial for companies, as it determines the level of risk they face when demand fluctuates. Not all costs adjust flexibly to changes in production volume. Think of the machines necessary for making the pencils. Usually, the company owns these machines. If demand suddenly shrinks, the company still owns the machines—and the costs connected to them remain, no matter how much is produced. These are fixed costs.
Fixed costs limit a company’s flexibility. Therefore, many companies try to reduce the share of fixed costs. If you own a taxi company, you most likely have several cars. These are fixed costs, as you cannot easily get rid of them. Of course, you can sell them, but doing so takes effort, and you may not get a good price.
Fuel for the cars, on the other hand, is a variable cost, since it depends on how much you drive. If you don’t have any passengers, you don’t need to refuel as often.
Now consider Uber, the company that revolutionized the ride-hailing industry. One approach Uber could have taken was to buy a fleet of cars, but this would have posed a major risk during times of weak demand. Instead, Uber chose to operate without owning any cars and pays drivers per ride. The drivers own the cars. In doing so, Uber managed to turn a cost that is usually fixed (the cars) into a variable one (cost per ride).
Please note that the risk of owning the cars hasn't magically disappeared—it has simply been shifted to the drivers. But Uber gained a great deal of flexibility.
