Stickycosts-6.pdf

Comments: Here are some thoughts about why costs might not scale up and down as easily as our cost-volume-profit equation suggests:

• Management can be optimistic about the future and builds capacity for expansion while managment might be reluctant to reduce capacity.

• Management becomes “attached” to the new (costly) activities and is reluctant to cut it.

• Management engages in “empire building” at any opportunity and is reluctant to cut it. Management may believe that they will gets paid more if they are responsible for larger organizations.

• Some productive activities can be difficult to start and it may be cheaper to hold onto it for a period or two rather than eliminate it. For example, even it you don’t have immediate work for an employee, you might continue to pay them rather than risk losing them to another company and need to search for workers again when activity picks back up.

Problem statement I was looking at a lot of data across a lot of years, companies, and industries and I noticed the following: When sales increased by 10 percent, total operating expenses increased by 9 percent. When sales decreased by 10 percent, total operating expenses decreased by only 5 percent. Maybe this pattern of total operating costs could be described as ‘sticky.’ Costs seemed to readily go up to follow sales, but costs did not decrease as readily when sales fell. Here’s a graph:

Required: 1. Why might costs be sticky? I’ve provided some starter ideas. Feel free to develop your own.

2. What does a sticky cost mean for our ability to build cost-volume-profit representations for the organization? You must state how a sticky cost affects the graph or the equation. For example, let’s say that you are at 100,000 units of production. A typical variable cost might be \$10 per unit. A sticky approach might mean that management is reluctant to cut variable cost. Does that means that the actual variable cost when reducing activity will be more or less than \$10 per unit? In that case, the total cost line would not be a straight line.

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