Short-Term Decision-Making

Question: Costs that vary in total with changes in activity are called variable costs. What do we call costs that remain the same in total with changes in activity?

Answer: This cost behavior pattern is called a fixed cost. A fixed cost describes a cost that is fixed (does not change) in total with changes in volume of activity. Assuming the activity is the number of bikes produced and sold, examples of fixed costs include salaried personnel, building rent, and insurance.

Assume Bikes Unlimited pays $8,000 per month in rent for its production facility. In addition, insurance for the same building is $2,000 per month and salaried production personnel are paid $6,000 per month. All other fixed production costs total $4,000. Thus Bikes Unlimited has total fixed costs of $20,000 per month related to its production facility (= $8,000 + $2,000 + $6,000 + $4,000). If only one bike is produced, Bikes Unlimited still must pay $20,000 per month. If 5,000 bikes are produced, Bikes Unlimited still pays $20,000 per month. The fixed costs remain unchanged in total as the level of activity changes.

Question: What happens to fixed costs on a per unit basis as production levels change?

Answer: If Bikes Unlimited only produces one bike, the fixed cost per unit would amount to $20,000 (= $20,000 total fixed costs ÷ 1 bike). If Bikes Unlimited produces two bikes, the fixed cost per unit would be $10,000 (= $20,000 ÷ 2 bikes). As activity increases, the fixed costs are spread out over more units, which results in a lower cost per unit.

Table 5.2 "Fixed Cost Behavior for Bikes Unlimited" provides the total and per unit fixed costs at three different levels of production, and Figure 5.2 "Total Fixed Production Costs for Bikes Unlimited" graphs the relation of total fixed costs (y-axis) to units produced (x-axis). Note that regardless of the activity level, total fixed costs remain the same.

Figure 5.2 Total Fixed Production Costs for Bikes Unlimited

Business in Action

United Airlines Struggles to Control Costs

United Airlines is the second largest air carrier in the world. It has hubs in Chicago, Denver, Los Angeles, San Francisco, and New York and flies to 109 destinations in 23 countries. Destinations include Tokyo, London, and Frankfurt.

Back in 2002, United filed for bankruptcy. Industry analysts reported that United had relatively high fixed costs, making it difficult for the company to cut costs quickly in line with its reduction in revenue. A few years later, United emerged from bankruptcy, and in 2010 merged with Continental Airlines. Although financial information was presented separately for each company ( United and Continental) in 2010, both companies are now owned by United Continental Holdings, Inc. The following financial information for United Airlines is from the company's income statement for the year ended December 31, 2010 (amounts are in millions). Review this information carefully. Which costs are likely to be fixed?

Although we cannot identify all fixed costs with certainty, several costs likely fall into this category: salaries (for union employees, such as pilots, flight crews, and mechanics); aircraft fuel (assuming flights are not easily canceled); aircraft rent; and depreciation. These costs total $11.1 billion, or 60 percent of total operating expenses (rounded). Fixed costs are clearly a large component of total operating expenses, which makes it difficult for airline companies like United Airlines to make short-term cuts in expenses when revenue declines.

Committed Versus Discretionary Fixed Costs

Question: Organizations often view fixed costs as either committed or discretionary. What is the difference between these two types of fixed costs?

Answer: A committed fixed cost is a fixed cost that cannot easily be changed in the short run without having a significant impact on the organization. For example, assume Bikes Unlimited has a five-year lease on the company's production facility, which costs $8,000 per month. This is a committed fixed cost because the lease cannot easily be broken, and the company is committed to using this facility for years to come. Other examples of committed fixed costs include salaried employees with long-term contracts, depreciation on buildings, and insurance.

A discretionary fixed cost is a fixed cost that can be changed in the short run without having a significant impact on the organization. For example, assume Bikes Unlimited contributes $10,000 each year toward charitable organizations. Management has the option of changing this amount in the short run without causing a significant impact on the organization. Other examples of discretionary fixed costs include advertising, research and development, and training programs (although an argument can be made that reducing these expenditures could have a significant impact on the company depending on the amount of the cuts).

In general, management looks to cut discretionary fixed costs when sales and profits are declining, since cuts in this area tend not to have as significant an impact on the organization as cutting committed fixed costs. Difficulties arise when struggling organizations go beyond cutting discretionary fixed costs and begin looking at cutting committed fixed costs.