Question

Sticky costs

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 expenses could be described as ‘sticky.’ Costs seemed to readily go up to follow sales, but costs did not decrease as readily when sales fell.

Required:

1. Why might costs be sticky? One proposal is that management is optimistic about the future and readily builds capacity for expansion and is reluctant to reduce capacity. Another, perhaps less rational thought, is that management becomes “attached” to the new (costly) activities and it reluctant to cut it. Finally, another less rational thought is that management engages in “empire building” at any opportunity and is reluctant to cut it. Feel free to select from these or suggest your own thoughts based on your experience.

2. What does this mean for our ability to build cost-volume-profit representations for the organization?

Answer 1

1. All the given options indicate towards one thing. In a growing organization, cost increases at almost the same pace at which the sales are growing but cost decreases at reduced pace when the sales are declining. For example - a company appoints more sales personnel to increase sales and increases marketing spend. In this case, company has added up cost to support increase sales.Now, if the sales are going down, it is difficult to cut manpower earlier appointed to increase sales but they are able to cut on increased marketing spend.

2. Cost volume relationship need to be established cost component wise. For example- Direct costs are mostly proportional to increase in volume. Fixed costs does not changes until company need to expand. Semi variable cost like (SG&A) does not changes much with change in volume but can be reduced over a longer duration.