Happy Sunday. I hope everybody is having a great weekend. Today, I want to talk about an important finance principle that marketers and finance people need to get right for a direct-to-consumer business. That is, you need to be really clear about which expenses of yours are fixed and which are variable. Why is that important?
First, I should define fixed versus variable expenses. Variable expenses are any costs that your business incurs that are directly proportional to the amount of revenue you create. You know on a per-order basis what your cost is for these. This means you either pay on a per-order basis, like your Shopify fees or payment processing, or you know what your costs are per order, like your Cost Per Acquisition from paid media. You can look at how much you spend and how many customers you've acquired.
Then you have your fixed costs. These are costs that, regardless of your sales or revenue, are relatively the same. Yes, maybe you need a bigger office or more people on your team if you're making $1,000 versus $1 million. But it's not linear. It's not one-for-one with sales. These are called fixed expenses or OPEX. There's some gray area here, which I'll get into in a minute. Why is it so important to know which costs in your business are fixed? Because of something called Operating Leverage.
Operating leverage is the concept of getting some efficiencies in your business as revenue scales. Variable costs will scale, but the non-variable costs won't scale with revenue the same amount. Let's say you're going to spend $100,000 on payroll. Would you rather your revenue be really high or really low to help cover that? Operating leverage is cool because sometimes the same team can produce 2 million in revenue and 4 million in revenue. Your payroll is the same, but you can make more revenue, and more contribution.
Things are never truly fixed. You probably do need more staff if you double your business, but you don't need to double your team. That is called operating leverage, and it's one of the most important things we have in DTC.
When you are forecasting your business for the year, you can really see this phenomenon really take effect if you have things set up correctly. So my take is, go through your P&L and your Chart Of Accounts with a fine tooth comb and make sure you have things coded correctly
You have three types of expenses.
Directly Variable Expenses - Ad spend, Shopify platform fees, SMS sees, fulfillment expenses, merchant processing, shipping, etc. I put SMS in here because we get billed per send, but email is much more fixed so I personally do not. If you are forecasting 50% growth in revenue, these should increase 50% as well.
Mostly Variable Expenses - There are still marketing expenses, so tecnically they are variable. But they definitely do not scale as linearly as the above expenses. These may be influencer costs, content, etc;. I find these to be on the brand side often. You still want them in marketing and they are variable, but if you are forecasting 50% growth you shouldn't expect these to go up as much as above. So I would keep them seperate and get a feel for how variable these are for your business. We definitely spend more on content or photo shoots now than a year ago, but it's not by much.
Fixed Expenses - These costs are not marketing expenses. These are rent, personnel, freelance support, and softwares that are not tied to sales. Again, there will be some growth in many of these as your business grows. But some of these expenses might not need to grow at all if you are growing 50%.
Now that you have these organized for your business, you can see how powerful this concept of Operating Leverage is. As you forecast for an entire year, you can really see it play out.
This also becomes extremely helpful when things go south. Say you're not having a great month, where you're not hitting MER targets and you need to decide whether you pull back spend to hit MER, or keep spend and keep volume at a lower efficiency.
Understanding your true fixed costs, so you know what you need to cover in Contribution Margin to at least break even. If you didn't, you might think you need to make more to cover things like 3PLs, Shopify, SMS, etc. But let's say it's a rough month, you can decide to pull back on all variable costs and save your dollars for a better moment. The only way to do this with confidence is if you truly know what you need to make in contribution to cover those fixed costs . Otherwise I've seen people just spend to hit revenue targets to cover costs, without knowing what their fixed cost basis is.
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Alright, get some shut eye tonight because it's going to be another busy week. Best of luck if Meta bugs have been affecting you! Praying things turn around soon.
-Cody