One key element to a business prosperity and possibly even survival is the cost strategy it follows.

By cost strategy we mean the strategy you adopt with regard to the cost drivers in your business. To understand this distinction, you need to clearly understand the difference between two completely different cost drivers. Accountants call these drivers variable costs and fixed costs.

First let's be sure we understand the concept of variable cost. A variable cost is one that is driven by sales volume. When sales increase, these costs increase, when sales disappear so do these costs. Cost of goods sold and sales commissions are examples of variable costs.

A fixed cost, on the other hand, is one that tends to be driven by time. They are the same regardless of the volume of sales. Rent, interest and salaries usually are fixed costs.

With this distinction clearly in mind, you can develop a strategy that favors variable costs or fixed costs. Any cost element can be structured to be either variable or fixed.

Let's take a couple of examples. Usually rent is fixed. The amount is due whether you are selling a lot or a little. However, if you negotiate with the landlord to pay rents based upon a percentage of profits then rent becomes variable rather than fixed.

Let's look at another example. Suppose you have a commissioned salesman and agree to pay him a salary. You've converted a variable cost to a fixed one by a simple negotiation.

Which cost structure is better?

The answer to that question depends on what you think the future holds. Let's use the following table to illustrate this concept. Suppose we have two companies both in the same industry and both selling the same products. Company A has been purposely structured to favor fixed costs and Company B has been structured to favor variable costs.

This first table shows the difference in cost structure with identical performance.

Both companies have identical profits on the same sales volume. On the surface, we would consider them equally well managed. However, look at the change in results as sales double.

Clearly company A is out performing company B only because the cost structure favors fixed costs. A fixed cost structure is clearly more profitable if sales are growing. But what happens if sales go down? The following table assumes sales drop in half.

Company A is losing money fast while Company B is at breakeven. Were the downturn to continue for an extended period of time, Company B would survive and Company A would go out of business.

What's the business lesson?

Following a fixed cost strategy will make sense if you are confident that you will grow in the future and if you have sufficient capital to allow you to easily maintain your business through temporary market downturns.

On the other hand, if you don't have a lot of capital or if future sales are uncertain or cyclical, you need to be more conservative and structure your costs to favor the variable model.