3 min read

Variable & fixed cost

Recently, I had an opportunity to work for an Oil refinery mechanical contractor. The contractor had taken a fabrication job contract for 3 years at a renowned refinery. The problem given to me was that the contract work was going in loss and the contractor wanted me to verify the cost calculations before he finally closes his shop at the refinery.

After seeing the operations at the site, I spent a lot of time collecting worker attendance cum wages records, measurement records, the contractual agreements having unit rates for different activities, and a lot of other data.

On diving deep into the financial calculations done by the contractor team, I saw that they had calculated revenue and subtracted the overall cost with it. This resulted in a loss in the range of 20k per fabrication unit.

The first thing, I did was to understand the full operation, team composition and put all the learning in the form of assumptions or inputs to the study. I shared these assumptions or inputs with all the team members of the stakeholders. I received a lot of suggestions and a few assumptions were heavily debated among the teams. After some time these assumptions were frozen as everyone agreed to them.

I had studied cost model development during my course work in microeconomics at ISB-Hyderabad. I used that framework to predict the allocation of different costs. The main feature of the cost model was to classify the costs into variable costs and fixed costs. Once I did, I saw that the average variable cost was higher by a couple of thousands from average revenue earnings. I challenged the site team, to do things differently so that the average variable cost could be brought below the average revenue number.

I also remembered, my Professor of microeconomics telling me that fixed costs can be brought down by increasing the work content. So, I asked the contractor to ask for more work from the refinery team. This will help home to bring thee fixed cost almost negligible.

The best part of the study was, at the start of the study the contractor was on the verge of shutting his shop at the refinery and after the study, he was asking for more work from the refinery. The main learning is that first bring down the variable costs, then increase the scope of work to bring down the fixed cost burden.

In case you or someone around you, is having a loss in his/her contract work or in his/her production unit, please connect with me- we can work together to find the different ways of doing the same work by proper allocation of costs. Don’t put yourself in too much pain, there is an opportunity in all the tough times.

Contact Prahlad