The standard analysis of the relationship separates fixed and variable costs; it suggests that costs increase or decrease by a constant rate when activity level changes. The relationship is generally true when there is no change in production capacity. But under certain conditions, capacity must change—then what is the relationship of costs relative to sales revenue? This is where the concept of “sticky cost” comes into play.
What is ‘Sticky Cost’?
“Sticky cost” describes the phenomenon that costs respond asymmetrically to changes in activity. More specifically, costs decrease to a lesser extent when activity level declines than they increase when activity level rises by an equivalent amount. In practice, activity level is measured by sales. A simple numeric example of cost stickiness is that costs increase by 7% for a 10% increase in sales, but drop only 3% (as opposed to 7%) for a 10% decrease in sales. Academic research finds that selling, general, and administrative expenses (SG&A) and cost of goods sold (COGS) can both exhibit cost stickiness. Consequently, an organization’s total costs could also show this asymmetric pattern. This observed phenomenon challenges the analysis based on the fixed cost and variable cost model, which suggests that changes in costs will be proportionate to changes in activity level. The phenomenon of sticky cost suggests that profits will be asymmetric when the activity level changes.
Signs that Costs Will Be Sticky
Costs are sticky because adjusting capacity down is more challenging than adjusting it up. First, entities with high committed resources are more likely to be affected significantly by sticky costs. For example, when demand goes down, businesses that are capital intensive (e.g., airlines) or labor intensive (e.g., healthcare organizations) have a difficult time cutting costs. The same is true for companies that have high investment in intangible assets (e.g., R&D, patents) and company culture (e.g., pharmaceutical companies).
Second, employee representatives serving on a board of directors is another sign that a company could encounter strong resistance to downsizing, including disposing of equipment or dismissing employees. This resistance makes lowering costs difficult during periods of declining sales. This effect could be stronger if a labor union is present.
Third, the sticky cost phenomenon is more likely to be observed in financially healthy companies. These businesses tend to be overly optimistic and are reluctant to adjust capacity down when sales decline. Even if losses incur due to insufficient adjustment to capacity, they have the resources to absorb them. It provides little incentive for management to take timely or adequate adjustment measures.
Last, sticky costs are also more common during a strong economy. A booming economy can make businesses underestimate the risk of declining sales and impair a decision to downsize even if they should do so. The impact on profit may come as a shock to management.
Management Decisions and Impact
Because of cost stickiness, profits decrease to a larger extent when sales fall than they increase when sales rise. The rationale behind management decisions must be investigated to determine whether the impact of sticky cost on profit is temporary or enduring.
To minimize resource adjustment costs.
Costs are sticky because management tries to avoid high adjustment costs of committed resources. For example, a shortage of registered nurses has been an issue for years. When the market demand from health insurers declines (for example, in 2016), hospitals rarely lay off their nurses because it costs less to maintain idle capacity than it does to cut resources first and then have to hire again when demand returns. In this case, management’s decision not to adjust capacity is a good one.
To prepare for future demand for product.
When management is optimistic about future growth, cost stickiness is expected. If managers are confident that a decline of sales will be temporary and anticipate that sales will ramp up soon, it seems appropriate to make only slight adjustments to committed resources.
Interestingly, when management has no clear picture of future demand or is uncertain of growth, cost stickiness is also possible. Management may wait for more confirmative signals (e.g., a smaller order from a major customer) before taking any action. This hesitation contributes to an insufficient adjustment to committed resources.
To optimize capacity utilization.
Management may simply decide that there is no need to adjust capacity after taking into consideration its utilization of capacity in the previous periods. When a business has been running at full capacity, a drop in demand could be a long-awaited release of pressure. As a result, the adjustment to the committed resources is minimal when sales decrease, but the purchase of additional resources could rise when sales increase.
To maintain competitive advantage.
A large project with the potential to create competitive advantage requires investment spanning several periods. Management must continue investing in the project even when sales decrease. During any sales-declining period, the investment amount may be reduced, but the reduction, in terms of percentage, may be lower than the percentage increase that corresponds to sales increases—that is, the cost response demonstrates asymmetry.
To protect labor market reputation.
While under pressure to cut costs when sales decline, managers may try to protect their company’s reputation in the labor market, especially those in labor-intensive industries. They may prefer not to terminate employees during difficult times if the firm has the financial resources to retain them. Instead, they may reduce labor hours per employee to control cost.
These reasons all assume that costs are sticky is because management delays downsizing due to a decline in demand for their products or services. It is worth noting that adjustment of prices rather than costs may also contribute to this phenomenon. Battling against a weak market, management may lower selling prices to stimulate demand while maintaining the current level of capacity. However, when dealing with a strong market, managers may increase capacity supply (as opposed to increasing selling price) during times of increased sales. This strategy could enable a company to survive but with lower margins.
If any of the aforementioned reasons—other than the pricing strategy—drives cost stickiness, then any adverse effects on profitability should be temporary. The business will be more competitive in the future. However, when conducting profit analysis, we should be wary of other factors. Factors derived from managers’ personal considerations or motives can also lead to cost stickiness. In these cases, profit could deteriorate over an extended period of time. For example:
- Managers gain personal benefits from running large organizations. They enjoy higher social status, self-esteem, and compensation from empire-building behavior. To keep these personal benefits, managers may try to avoid down-sizing as much as they can.
- Managers may also try to avoid the extra work and stress associated with firing employees. This reluctance to handle the psychological burden can produce little to no cost adjustment when sales decline.
Understanding sticky cost can provide a fresh perspective on examining business operations. The following are two examples where the concept of sticky cost can assist in a profit analysis.
Increase in the ratio of operating cost to sales.
Typically, an increase in the cost ratio suggests that margin is decreasing. It is frequently interpreted as a negative sign of future profits. The common assumption is that operating expenses change at the pace of sales revenues. Fixed costs are not affected by fluctuations in sales; the change comes from the variable component, which is proportionate to the sales change. An alternative, however, is that when sales decrease, an increase in the ratio could very well indicate that management intentionally maintains the level of marketing and administration effort in anticipation of a rebound in the near future. The increase in the ratio is thus a positive sign of future profit.
Profit estimates in the year of sales decline.
When companies prepare budgets, they run what-if scenarios to form expectations of profit when sales levels change. It is reasonable to expect profits to drop when sales decline—but when it really happens, the decrease can be much more severe than expected. This can be explained by sticky cost. In the year of sales decrease, management typically hesitates to adjust capacity, or the adjustment is not enough for various reasons described above. Moreover, the financial impact of the adjustment usually lags behind the decision itself. With the extent of decline smaller for costs than for revenues, the magnitude of profit decline will appear larger than expected, potentially creating a shock to both managers and investors.
In a related circumstance, if a business issues earnings forecasts based on its budgets, the forecasts would be less accurate in years when sales decline than when they rise. Consequently, investors will feel it is imperative to press for more information in order to process large earnings surprises—and company management should be prepared for this.
Advisory services will likely drive CPA firm growth in the coming years. A working knowledge of sticky cost can help CPAs add value; that is, incorporating scenarios of sticky cost will provide insightful services for client budgets, earnings forecasts, and business valuation. Identifying underlying reasons for sticky cost will further inform profit analysis and, therefore, management decisions.
Overall, CPAs should consider the following advice when providing high-quality advisory services:
- Avoid jumping to conclusions when conducting ratio analyses;
- Make a deliberate effort to incorporate sticky-cost scenarios into profit analysis; and
- Consider management’s motives behind cost stickiness.