12.17.2009

Fixed Versus Variable Costs


I took an early shine to accounting, completing two years in high school and even competing in and winning contests through the Future Business Leaders of America. I continued on at Wharton and earned a concentration in accounting as part of my degree. And yet, for all of the foundation and credentialing, I haven't really used my accounting side directly in my professional life.

But I am glad for all of the studying and all of the classes, for they have embedded in me some principles that find usefulness in new and surprising ways. Take, for example, the simple concept of fixed versus variable costs. If you sell soda, syrup is a variable cost: the more soda you sell, the more syrup you need. The rental payments on your syrup dispenser, on the other hand, are largely a fixed cost: you owe the same every month, regardless of whether you sell 1 cup or 1 million cups.

Basic enough. And yet it turns out that we struggle to understand whether something should be a fixed cost or a variable cost. I look at the whole "economy versus the environment" issue partly through this lens. Car "consumption" currently has a high fixed cost, low variable cost structure: cars are pretty expensive, but once we own them, there is a sense that it is marginally cheap to actually use them.

In fact, from an environmental standpoint, this is not quite right. In an environmental sense, our perception of the upfront cost is too high, and our perception of the ongoing cost is too low. If we adjusted ourselves, our car "consumption" would be more environmentally optimal.

In fact, this is the premise behind car-share programs such as Zipcar and PhillyCarShare. Instead of owning a car (or having to shell out for a second car), you merely pay for the hours you actually need it. This makes financial sense for a whole range of urban dwellers, from young'uns who want to do without a car altogether to families who only need that second or third car on occasion (and, at that, for an hour or two at a time, where a normal rental car isn't worth it).

What happens over time, according to my friends at PhillyCarShare, is that members' driving behavior changes. At first, they reserve cars in ways that mirror their current driving patterns: I need a car, I borrow a PhillyCarShare car, I return it. Over time, they realize that this form of car "consumption" is relatively "high variable cost" in nature, and they begin to bundle their trips, or figure out how to do without a car altogether, since now there is a relatively high marginal cost for the next use.

And this is how it should be, since gas is artificially cheap as it relates to the environmental, geopolitical, and infrastructural costs each extra trip adds to the system, and since each trip also adds to pollution, congestion, and other social costs. When we own our cars, it is relatively frictionless to impose these costs on others; when we have to pay as we drive, we make better decisions.

You can apply this logic to pay-as-you-drive car insurance as well; and jurisdictions are experimenting with the technological, logistical, and political ramifications of swapping the current gas tax with a "vehicle miles traveled" tax. All of this is good to explore, in my opinion. And all of this requires a fundamental understanding of the difference between a fixed and variable cost. Which makes me glad for all those hours of studying accounting. Who knew?

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