I’ve often said that corporate and personal finance are two very interrelated worlds. Here in Michigan, we have elected a governer with a high business acumen, as well as elected a mayor of Detroit with a corporate background. The public realizes that the government needs to run in a similar fashion to the corporate business model, and the end goal is to return a profit to the company and the shareholders. Running your household is essentially the same thing as running a company. Invest wisely, cut unnecessary expenditures, plan ahead, budget, and ultimately turn a profit. Instead of shareholders you have the members of the household, which is most likely your family. Well a key component of corporate finance is knowing the difference between variable and fixed costs, and how to manage them.
Granted I’m from the metro Detroit area, but I’m willing to bet most of you are familiar with the so-called collapse of the Big 3 automotive companies. General Motors is raring back to life, despite that annoying Government Motors moniker they are still eagerly trying to shake. If you invested $10,000 in Ford stock at it’s lowest point you would now be sitting on a boat load of cash. And Chrysler, while the runt of the litter, has made a key strategic alliance in Fiat, and has endless possibilities. Still, it begs the question, where did these companies go wrong? Some will say quality, stodgy and bureaucratic management, slow to respond to the market, etc. Many of those would be correct, but in face of adversity these companies successfully turned most of the issues around, and yet they still couldn’t turn a profit.
Legacy costs, or fixed costs, are what drove the automotive industry into despair. In the automotive industry, legacy costs are typically salary and benefits related. In many other industries they use this term to reference any old fixed costs that were established under prior leadership and direction. You can be as efficient as you would like, produce something in it’s most efficient manner, and still be unprofitable. The automotive companies, and many now the public sector is experiencing this as well, had been too generous and unrealistic with medical and retirement benefits for their employees for far too long. Eventually they experienced the wrath of a very unsustainable model.
I know, I have gone on and on about everything other than how this affects you as individual! Guess what? The sooner you understand the difference between variable and fixed costs, the better off you will be financially. You may like purchase a daily latte, go to an expensive salon each month, enjoy weekly massages, or perhaps a routine weekend outting at the golf course. These are all variable costs, in that you can control how often and how much you spend on these items. They are easily cut from your budget when you need to lower your spending, and what I term “the low hanging fruit“.
Now let’s consider the typical fixed costs that weigh down the average person. A mortgage may be the largest fixed cost of the bunch. Certainly it wasn’t the daily latte purchase that drove the housing bubble to burst, it was expensive mortgages with unsustainable monthly payments that left us where we our today. Too many people bought too much house with too little cushion. I understand the want for a larger home, but only buy what you can COMFORTABLY afford, not what you can narrowly pay for each month. I’m willing to bet that student loans are actually the next highest fixed cost for the average person, if they aren’t yet, then they soon will be. I pay about $425 a month on my student loans, yes they can be lowered by extending the time to pay back, but this would cause me to pay more interest over my lifetime. Affordable education is out there, you just need to look for it, as well as be realistic as to how you want to use that education throughout your life. I would say that car payments would next in line for fixed costs that burden us. I don’t live in an area with viable mass transporation, so a vehicle is a necessity. Still, we can control whether we lease or buy, new versus old, and how much we care to spend overall. Ever see Operation Repo? Yeah, well too many people get in over their heads and fail to keep up with their car payments. I’m will to bet that if you are having financial difficulties, it’s these types of fixed costs that are eating up a majority of your paycheck. The worst part about fixed costs is just that, they are FIXED. It’s not easy to get out of a 30 year mortgage that you can’t afford, at least not without destroying your credit. What about a 10 year student loan? Or a 5 year car loan? When you need to cut back on expenses in a hurry, there isn’t much you can do about these expenses. The best way beat the downward spiral of fixed costs is to avoid them, and to not let them consume you to begin with.