Companies can lower their break-even point by sharing risks with partners. They also enjoy the benefit of reduced capex and increased specialisation.
We live in an uncertain world and this is especially true in the world of business. Rapid change has resulted in shorter product life-cycles. In this scenario, companies that thrive are those that are able to scale up fast, gaining first-mover advantage.
A key underlying factor that links scalability and managing uncertainty is the cost structure — to be more specific the ‘break-even point’ (BEP). BEP is an often ignored metric in analyst reports, thanks to their obsession with ‘terminal value’.
BEP, in simple accounting terms, is fixed costs divided by contribution, where contribution is measured as sales minus variable costs. Companies with low BEP have a low fixed cost structure and less earnings volatility compared to peers that have higher BEP within same industry.
This should typically translate to relatively lower “beta” (measure of risk) for low BEP companies and, therefore, less volatility in share prices, which can save risk-averse investors from a good amount of heartburn during harsh economic conditions.
COPING WITH VOLATILITY
Let’s look at the auto industry as an example, where Bajaj Auto has one of the lowest BEPs. Bajaj Auto’s BEP lies between 20 per cent and 30 per cent compared to its peer group average of 50-60 per cent.
What this means is that, Bajaj can withstand greater volatility in sales compared to its peers in the two-wheeler industry, without its bottomline becoming drenched in red. Even if its sales (and the contribution) drops by, say, 50 per cent, Bajaj would still be able to show profits, unlike some of its peers. Given the cyclical nature of the auto sector, it is a big plus to have a low BEP.
A couple of other examples of low BEP companies relative to their respective industries are Apple and Airtel.
How do companies achieve low BEP?
BRANDING AND DESIGN
While the rest of the auto industry prides itself on its manufacturing and engineering prowess, Rajeev Bajaj pictures himself to be in the FMCG business. When the basic definition of the business changes, it opens up a whole new set of possibilities.
What are critical for a FMCG business are branding, product ideation/design, packaging and distribution — not necessarily manufacturing.
So Bajaj extensively uses its vendor network for getting a good portion of manufacturing done outside, for example, the company sources components as higher value-added systems and sub-systems that can be quickly assembled compared to sourcing parts that need significant further processing.
On the design front, by tying up with KTM — a global major in bikes — it is able to optimise on R&D spend. By adopting platform and parts standardisation across many of its models, but retaining distinct exterior styling, the company is able to showcase different models while achieving cost-efficiencies in the back-end.
REVENUE-SHARING MODEL
The telecom industry, by nature, has a high fixed cost structure, with escalating licence fees for operators. But within the industry, Airtel is one of the players that was an early adopter of low BEP model.
It was one of the first companies in the Indian telecom space to outsource a major chunk of its IT and back-office operations to IBM, through an intelligent revenue-sharing model, that immediately converted its fixed costs to variable.
Hiving off and recently listing its telecom tower business, is another move in line with low BEP philosophy with respect to its core business as a service provider. Temp-staffing for various roles is another key strategy that helps lower BEP.
Needless to say, Apple changed the consumer products market, by focusing on product design, marketing and retailing, while it outsourced manufacturing almost entirely. That’s really a bold move for a hi-tech company manufacturing very sophisticated products, and selling it for a huge premium. Obviously, this wouldn’t be possible without capable partners and an extremely rigorous quality check process.
The common thread connecting companies that have managed to reduce BEP within their respective industries seems to be a clear identification of what their core competence actually is. They then choose to prioritise and focus on these internally, to sharpen competitive advantage, while figuring out ways to get other things done externally/with partners.
How does low BEP help manage uncertainty and help scalability?
Low BEP companies reduce risk and share it with partners by not carrying all fixed costs related to revenues by themselves. Such companies also enjoy the benefit of reduced capex and increased specialisation.
When business volumes shrink during a downturn, the parent organisation is not forced to bear the full brunt and when growth is more than expected, it can save on capex for expansion. As Mohnish Pabrai mentions in investor parlance, that’s like heads I win, tails I don’t lose much.
Hyper growth companies, that is, the likes of Micromax, Apple, and so on, have been able to achieve massive global scale and product penetration within a matter of few years because they do not have to do everything in the value chain themselves. In fact, they believe in ‘less is more’ and depend on multiple external partners to help them go to market, both on the front-end and back-end.
CHALLENGES AND RISKS
Making fixed costs variable could come along with the need to pay higher cost per unit to the vendor. But, often times, one realises that the total cost of purchase is actually less, after taking into consideration the total cost of doing things in-house.
This could be because vendors often specialise and have scale advantages of offering similar product/service to other organisations. However, the downside of this is confidentiality and IP protection. Quality is also a key issue that companies which outsource, need to have a watchful eye on.
From an analyst standpoint — tracking and reporting of fixed and variable costs, which is primary to the exercise for BEP computation, benchmarking and analysis, is a point of concern.
Many companies either have a wrong classification/capturing of cost heads or do not bother to disclose the split, which is not mandatory. So analysts need to grapple with lack of information and inaccuracies, which hamper decision-making.
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