It may not be obvious, but educating college students and building military hardware are similar in some important ways, ones that become particularly vexing in an economic downturn.
In both sectors, fixed costs are high compared to variable ones. Fixed costs are ones that don’t vary with output. Teach more students or build more fighter jets, and fixed costs don’t increase. By the same token, when the number of students or planes or ships shrinks, these costs don’t. Indeed, until you close down the whole operation, fixed costs need to be paid even when output is zero.
At a college, some of the fixed costs are personnel. You need a president, a registrar and various deans. You also need professors and, to the extent they have tenure, they cannot be laid off easily. And you need to heat, light and clean the buildings.
A defense contractor needs the same sort of permanent cadre of managers. There are factories with costs that have to be amortized regardless of how many units turned out each year. But in this industry, the biggest fixed cost is the engineering time that goes into designing and testing a new plane, ship or tank.
Variable costs are those that go up and down with production. At a college, it is consumable supplies like paper for the copy center or food for the dining hall. For defense contractors it is raw materials like steel or aluminum, piping or wiring, circuit boards, electrical sensors and optical devices.
When college enrollments drop, it is hard to cut costs. Until this year, my introductory econ classes always hit the limit of 25 students. This term I have 10. The college still has to pay me and light and heat the classroom. I even use up the same amount of chalk, regardless of how many seats are occupied. In the very short run, about the only cost decrease is in paper for tests and handouts.
If the Pentagon decides to buy only 187 F-22 jets instead of 1,000, you still need all the same design work, the same jigs and tooling, the same factories. You will buy less aluminum, titanium and graphite and pay fewer hourly workers.
So in both cases, as sales drop, revenues decrease much more than costs. The per-unit cost of whatever you produce rises, often dramatically.
Payment arrangements and fundamental demand for the products are different, however. Contractors are paid for design work separately from actually building the hardware. So payment for at least some of the fixed costs are guaranteed. And in the less-than-perfectly competitive world of defense procurement, the contract price for each unit still produced may rise.
Higher education isn’t perfectly competitive either, but it is hard for colleges to raise tuition just because fewer students are enrolling compared with a year ago.
The question of which costs are variable or fixed depends in part on how long a period of time one considers. In the longer run, defense companies can close factories and lay off engineers as well as machinists.
Colleges can lay off some administrators, not renew contracts for adjunct faculty and not replace tenured faculty who retire. They can close programs or majors with low enrollment.
They also can add programs that might draw in new students without increasing costs much. A weekend or evening program uses existing buildings that need to be heated and cleaned anyway.
But it is not easy being the manager of any operation where most costs are fixed, whether you are turning out philosophers or projectiles.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.