Finding Budget

Flexibility - or Not:
The Impact of Fixed and Variable Cost
In a time of reduced defense budgets, financial managers seek to optimize
budgetary resources while allowing the flexibility to absorb such reductions.
Tom Willson explains that understanding both fixed and variable costs are
fundamental to establishing a budget’s flexibility.

BY TOM WILLSON

The Journal of the American Society of Military Comptrollers ■ 31

 Finding Budget Flexibility - or Not: The Impact of Fixed and Variable Cost

W H Y WE CARE? Cost Components

Anyone participating in the federal budgeting process over the past
few years has most likely observed a general recurring trend in an Cost: outlay or expenditure
increasingly competitive fiscal environment— the defense budgets Fixed Cost: a cost that must be incurred for legal or
are getting smaller. If the budgetary reduction is directly proportional fa c t o f life reasons
to specific measureable events, such as a reduction in workload or a
Variable Cost: a cost that does not have to be incurred

reduction in the price of goods or services, the relationally comparative

decrease in budgetary resources would be considered a resource-neutral
event and of no further material concern. The underlying (and often
unstated) assumption is that all budget resources are variable; any
reduction to the budget can be applied in a linear and equal relationship
to the amount of goods or services purchased. The fundamental fault
with that assumption is that it ignores the fixed component of cost. The
greater the amount of fixed cost, the less flexibility within the budget to
FIXED COSTS BY APPROPRIATION
absorb a reduction. To understand flexibility within a budget, one must
The US Congress funds defense using appropriations primarily
understand the two components of cost: fixed cost and variable cost.
differentiated by purpose. Appropriations are often called colors of
money. These may be further divided by service (USA, USAF, USN,
COST COMPONENTS
and USMC) and component (Active, National Guard, and Reserve
Cost is often thought of as the price we pay to get a good or service.
Component). All appropriations are subject to reprogramming thresholds
The Merriam-Webster on-line dictionary defines cost as: the amount or
in accordance with the applicable congressional appropriation act(s) and
equivalent paid or charged for something, or the outlay or expenditure
those thresholds further determine the limits of variable cost. Further,
(as of effort or sacrifice) made to achieve an object.1 There are two
all Executive Agency funding is considered fixed because a Service or
components to cost: fixed cost and variable cost. In simple terms, the
agency cannot unilaterally decide to use the dollars associated with the
difference in the nature of a fixed or variable cost is whether or not I
function for any other purpose. For this discussion, Special Interest (or
have a choice in consumption. If I must do something—for a fact-of-
pass-through) appropriations are not included in the list below because
life or legal basis in which I have no choice— it's a fixed cost. I cannot
by their specific purpose when appropriated, they are fixed cost. The
forego consumption and use fixed cost resources to pay other bills. If I
following is a list of the most common appropriations:
can choose whether or not to do something and/or control the amount
consumed (to include doing nothing/using none)— it's a variable cost. Operation & Maintenance (O&M). This appropriation is most often the
I can forego consumption and use variable cost resources to pay other targeted billpayer for overall defense budget reductions because
bills. Some costs are a mixture that contains both fixed and variable O&M has the largest relative share of variable dollars which can be
components. A mixed example is a monthly electric utility bill. Many deferred or avoided entirely—without needing congressional approval.
normally have two separate and distinct charges: 1) an infrastructure Generally training (institutional and operational), maintenance (facility
charge that must be paid regardless of whether or not any electricity is and equipment), and the other operational functions (i.e., recruiting,
used—this is the fixed component of the bill, and 2) a consumption- transportation, headquarters activities, etc.) are all variable cost, except
based charge that depends on how much electricity is used during a for civilian pay (CIVPAY). CIVPAY is considered a fixed cost in the year
billing period—this is the variable component. Even if it were possible of execution and an entitlement because if you do the work, you must
to use no electricity during a billing cycle (a variable cost), there is still be paid. CIVPAY can, however, be deferred or avoided using furlough
a cost for the infrastructure (a fixed cost). The budgetary challenge authority. In that case, no work was performed, so no pay is due.
is that when a budget is reduced, its fixed component may not also Military Pay (MILPAY). Considered a fixed cost as an entitlement similar
become smaller. In fact, the fixed cost component may not change at to CIVPAY. Two variable items where you can avoid increasing cost are
all. Any reduction must then only be absorbed within the remaining delaying/deferring promotions and permanent-change-of-station (PCS
variable cost component. Because of the inflexible nature of a fixed travel). Minimal or no annual pay raises for either or both MILPAY and
cost, the true impact of a budgetary reduction is always effectively CIVPAY are another way to avoid increased cost.
greater than what simple division to calculate the specified percent
Research, Development, Test & Evaluation (RDTE). Considered a fixed cost
reduction would lead one to assume. In analysis, this true impact of
as Congress appropriates funding for RDTE items at program element
a reduction is called the effective rate or e-rate. To further examine
level. CIVPAY in RDTE is also a fixed cost as it is in O&M.
the more restrictive impact of fixed cost, let’s drill deeper into the two
common views of what makes up a budget— either by Appropriation or Procurement (multiple). Considered a fixed cost as Congress appropriates
by Element of Resource (EOR). funding for procurement items at line item level.

•^To understand flexibility within a budget, one must understand

the two components of costs: fixed cost and variable cost.??
32 ■ A rm ed Forces C o m p tro ller • Spring 2014
 Finding Budget Flexibility - or Not: The Impact of Fixed and Variable Cost

Reprogramming Authority WITHIN an Appropriation

—NOT across Appropriations
(Consolidated Appropriations Act, 2014)

APPN MAX INTO MAX OUT Level o f Control OBL Avail

Absolute
Values- \
NOT Net \
RDTE + $10M Greater o f Program 2 Years
--has $10 M Element
CIVPAY - 20%

\
PROC + $20 M Greater of: Line Item 3 Years
\ $20 M 5 years SCN
T - 20%
H
B R O&M + $ 15 M - $ 15 M Budget A ctivity 1 Year
E E --has Many. BA 1
L S CIVPAY Sub-Activity
Lim itatio ns on
0 H Decreases
W 0 (OPTEMPO SAGs)
l
MILPAY + $ 10 M No Budget Activity 1 Year
D Congressional
Restriction

MILCON Lesser of: No Project 5 Years

--separate + $2 M Congressional
A pp ro pria tion + 25% Restriction
Act
Figure 2.

Military Construction (MILCON). Considered a fixed cost as Congress Transportation. Considered a variable cost. EOR classification does not
appropriates funding for construction items at project level. provide specific detail about what is being transported or how.

FIXED COSTS BY ELEMENTS OF RESOURCE IMPACT OF TIME ON FIXED COSTS

Elements of Resource is the other main way to view costs. The EOR Fixed costs reduce flexibility within budgets because fixed dollars
classifies the resource according to the nature of the usage rather than cannot be used either as a billpayer for budget reductions or as a
the purpose. The following is a list of the most common EORs: funding source to pay other bills. Only variable dollars can be used

Civilian Personnel. Considered a fixed cost as previously discussed. as billpayers. Besides color of money or EOR, time is also a factor to

Because of the magnitude of the cost of CIVPAY across the federal consider. The period of greatest flexibility within a budget is at the start

government, this EOR is often the most targeted EOR for reduction.
Military Personnel. Considered a fixed cost as previously discussed.
Travel. Organizations often differentiate between travel that is mission-
essential (ME) or non-mission essential (NME). Following those
classifications, ME is a fixed cost, NME is a variable cost. This EOR
is also a favorite target for cost reduction, although often there are
exceptions/exemptions for travel related to job-required professional
development and PCS travel.
of the fiscal year. Once a dollar is obligated, it becomes a fixed cost
because it can no longer be used for any other reason. As variable cost
dollars are obligated, they become fixed cost. Over time, the fixed cost
portion of the budget grows relative to the variable cost portion until,
at year end, the entire budget has been obligated and all dollars are
now fixed cost. Because of the reduced flexibility that occurs with the
passage of time, budget reductions are best addressed sooner rather
than later. With each passing day during the year of execution, there is
less and less flexibility.

Utilities. Considered a mixture of fixed and variable costs as previously

Fixed / V a ria b le Costs vs. T im e
discussed.
-- An Execution Perspective
Rents. Considered a fixed cost.

Contracts. Contracts can be classified as severable (variable) or non-

severable (fixed). Sometimes severance or termination costs can reduce
or even exceed any potential cost avoidance or savings.

Supplies. Considered a variable cost. This EOR is also a favorite target

for cost avoidance or savings.

Equipment. Considered a variable cost. EOR classification does not

provide specific details about what is being bought.
Figure 3.

The Journal of the American Society of Military Comptrollers ■ 33

 Finding Budget Flexibility - or Not: The Impact of Fixed and Variable Cost

Specified R ate vs. E-Rate SO WHAT DOES THIS MEAN?

This discussion assumes that budget reductions in defense are going to
In itia l B udget $ 1 0 0 M
B udget C ut $5M continue in the foreseeable future. To best inform leadership of the real
$M Variable impact of these reductions to organizations and operations, fixed and
O&M 50 Yes Specified Rate variable cost components must be determined and used in analysis. We
5 / 100 = 5% must also consider time as a further limiting factor to flexibility— sooner is
RDTE 15 No
better than later. Failure to incorporate fixed and variable concepts into our
MILCON 35 No Effective Rate
5 / 50 = 10% thinking will lead to incorrect assessments of the flexibility we truly have. The
Total 100
risk underlying the assumption that all dollars are variable is that a proposed
Figure 4. decrement may not be achievable due to fixed cost. The restrictions to
flexibility imposed by fixed cost may lead to the unintended consequence
CALCULATING THE EFFECTIVE RATE (E-RATE) of being forced to decrement variable cost in programs that otherwise we
Budget reductions are often expressed as a percentage reduction using
would not choose to reduce and the resulting mission degradation or failure.
division— the amount of the reduction as the numerator divided by the
E N D N O TE
total budget as the denominator. This percentage is the specified rate.
1http://www.merriam-webster.com/dictionary/cost, © 2014 Merriam-Webster, Incorporated.
As mentioned at the start of this discussion, the assumption underlying
the specified rate is that all dollars are variable and could be used as TOM WILLSON
billpayers for the amount of the cut. The more accurate percentage that Tom Willson is the Associate Director,

reflects a truer impact of the reduction should use only the variable cost Defense Programs, at the Whitman School
o f Management, Syracuse University. He
dollars in the denominator. There is no change to the decrement amount in
holds an MBA from Syracuse University
the numerator. The percentage reduction using only variable cost is known
and an MSA from Central Michigan
as the effective rate or e-rate. If any portion of a budget is fixed cost, the
University. Tom is a Certified Defense
e-rate w ill be larger than the specified rate. The implication of the e-rate is Financial Manager with Acquisition
that because it more accurately reflects the ability to pay the bill using only specialty (CDFM-A). He is a member o f
variable cost, it more accurately shows the true impact on the organization. ASMC’s Leatherstocking chapter.

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