Keep fixed operating expenses lean to navigate eCommerce seasonality

Aim to cover fixed operating expenses at a minimum

Profitability isn't just about driving sales; it's about managing costs effectively, particularly your fixed operating expenses (OpEx). Our previous article emphasized the importance of earning enough contribution margin to cover fixed costs. This article delves deeper into the significance of this principle.

Understand the components of OpEx

As you scan your eyes down your profit & loss (P&L) statement, once you've arrived at contribution margin, attention turns to fixed operating costs like payroll, rent, utilities, software and even brand marketing. Such costs are usually tied to time, often quoted as monthly bills. That's an important call-out in the context of "covering your fixed costs with contribution margin", because as sales fluctuate from busy seasons to quiet lulls, these bills remain the same.

You should set up your financial reporting in a way that clearly isolates the components of OpEx. In your financial model, you should be able to show a breakdown of the 'Total fixed operating expenses' line item.

Assess your operating leverage

One of the innate traits of consumer product brands is that you can build a business with low operating leverage. But what does "operating leverage" mean in practice? In simple terms, the higher your fixed operating costs are (in proportion to your total costs), the higher your operating leverage is. Low operating leverage can be hugely beneficial, giving you the flexibility to shrink costs in response to declining revenue. In a downturn, it could be the difference between survival and bankruptcy.

The exact formula you can use is as follows:

operating leverage = contribution margin / operating profit

High operating leverage isn't inherently bad. It allows you to benefit from higher margins when sales are increasing. But leverage always works both ways. In turbulent times, high operating leverage is not good, because you're left with fixed cost obligations even as sales dip.

To really bring this concept to life, let's walk through an example that compares the unit economics of BizA and BizB side-by-side. Both sell a very similar product, but there's a key operating difference to note: BizA manufactures their products in-house with full-time employees, while BizB source their product from a third-party manufacturer.

As you can see, the decision to manufacture in-house has widened the gross margins of BizA. Product costs are lower, they spend less on freight, and fulfillment is cheaper because they pick and pack in their own warehouse. But you'll also notice that their fixed operating costs are much higher than BizB. By moving operations in-house, they've added additional fixed operating costs like salaries, rent and electricity. In contrast, because BizB outsources manufacturing, they pay a higher variable cost per unit, but in doing so they are able to run their business with a much leaner OpEx figure.

Now let's assume both businesses have the same marketing efficiency ($45 to acquire each customer) and sell the same number of units (10,000). As it turns out, despite having a different ratio of variable:fixed costs, both businesses have generated the same operating profit of $40,000 at this sales volume. So it's much of a muchness, right? Not so fast. It's only when you consider fluctuations in sales that the concept of operating leverage becomes really important.

If we apply the above formula to each business, we can calculate their "operating leverage" to be 10.50 and 3.75 respectively. BizA is much more "leveraged" than BizB. For them, a 1% increase in sales leads to a 10.5% increase in operating profit. But the reverse is also true. If sales drop suddenly, their operating profit takes a significant hit.

You can visualise a series of "what-if" scenarios on a graph to really understand this concept. What if both businesses sold double the number of units? What if they sold half? As you can see, BizA's high operating leverage makes them much more prone to wild swings in operating profit.

Recognize the seasonal nature of eCommerce

One of the biggest challenges you face as an eCommerce operator is the pressure that seasonality puts on your cash flow. Sales can fluctuate drastically from month to month, but you need to have enough cash to cover fixed operating expenses in every month of the year. It can be daunting to have to rely on a hugely successful "peak season" to build up enough cash to keep the lights on during quieter months.

Compared to industries with a more predictable revenue profile (e.g., a SaaS subscription), consumer product brands are faced with more dramatic seasonal swings. Our data, and your lived experience, clearly illustrates this. Some brands generate as much as 80% of their annual revenue in just a few months. The seasonal nature of our industry makes the decision of whether or not to take on additional fixed costs, like a full-time employee, more difficult. A swimwear brand still needs to pay their FTE salaries in winter!

Let's continue our BizA and BizB example to demonstrate how high operating leverage leads to more pronounced swings in operating profit for a seasonal business. Assuming the unit economics and fixed costs remain consistent year-round, we can adjust the units sold for the remaining months and assess the impact of this on operating profit.

For the same number of units sold...

... monthly operating profit varies significantly

For the exact same number of units sold, BizA's high operating leverage means they experience higher peaks and troughs for monthly operating profit. Now here's where it gets interesting... If you add up the monthly operating profit figures to calculate an "annual profit" for each business, you'll find that both BizA and BizB arrive at the exact same number of $480,000.

A junior analyst examining the annual P&L of these businesses side-by-side might mistakenly think they are comparable companies with similar levels of risk. But in reality, BizA may struggle to stay afloat during quieter periods like February, when they'd be forecasted to make an operating loss of $254,000. While operating profit does not directly reflect a company's cash flow, it gives us a good indication of the challenges they may face. To arrive at the theoretical $480,000 annual profit figure, BizA must stay alive first and continue to cover their fixed operating expenses as they fall due. And they need enough cash to do so. That's why this maxim should always be top-of-mind: it's a combination of profitable unit economics and careful cash flow management that makes a good business.

Keep a lean OpEx to navigate seasonal waves

In most cases, keeping your OpEx lean is a huge advantage to navigate seasonality. Even though you sacrifice some gross margin, it means you have the flexibility to dial operations up and down during the year. In quieter periods, you don't have a huge fixed cost obligation that puts a strain on cash flow. And for busier times of the year, you can ramp up spend to capture demand.

So what should your OpEx be as a percentage of revenue? Unfortunately, there's no simple answer. "It depends" on a variety of factors specific to your business. Only you have a true understanding of these nuances and trade-offs, so a prescriptive number might be misleading. But to get a rough indication of where your OpEx should be as a % of revenue, here's what you can do:

1. Look at best-in-class benchmarks for your product category, pulled from our Profits in Focus eBook.

2. Work backwards from an operating profit target

There are a number of "levers" at play in your P&L. Improving one or multiple of these metrics should lead to an improved operating profit margin.

1. Price: can you raise prices without a significant hit on demand?
2. Variable costs per unit: can you reduce product, freight, fulfillment or transaction costs?
3. Ad spend: can you improve your ad performance and spend less to acquire customers?
4. OpEx: can you trim OpEx?

The focus of this article is keeping a lean OpEx, so let's assume that's the lever in play, with price, gross margins and ad performance remaining constant. OpEx is the most inflexible to change, so some upfront planning is important. You can't scale or cut headcount or warehouse capacity on a whim in the same way as ad spend, so you need to make careful, long-term decisions. A question you can ask yourself is: what's the max I can spend on fixed operating expenses per month to achieve my desired operating profit margin?

Using the calculator below, you can start from the bottom and set a target for operating profit, say 15%. Based on your unit economics, it calculates the max you can spend on OpEx to achieve that result. Now play around with various figures for "units sold" and look at how this max threshold swings wildly. In your quietest months, how much are you overspending on OpEx? Finding an appropriate OpEx range for your business is a judgment call that needs to factor in the revenue peaks and troughs you expect throughout the year, avoiding situations where bills for a particular month can cripple your cash flow.

Look at how a lean OpEx creates wiggle room elsewhere

OpEx is inflexible and difficult to change month-over-month. Making the decision to run your business with a lean OpEx lowers the hurdle you need to cross to reach profitability and creates flexibility elsewhere. For example, your break-even MER is lowered, meaning you can remain profitable with "less efficient" ad performance. And in quieter periods where MER drops below your break-even point, you can pull back on ad spend much quicker than you could cut OpEx.