MANAGING COSTS IN A DOWNTURN

By Mark Anderson and Dongning Yu, Haskayne School  Business, University of Calgary

From the IAFEI 3rd Quarter 2020 report:

This paper studies several factors to consider in cost management in a downturn: sticky costs , agency costs, adjustment costs, and future expectations.

China’s economy is growing at its slowest pace since the financial crisis, according to CNN business (October 19, 2018). the world’s second-biggest economy grew 6.5% in the third quarter of 2018, which marked the weakest quarterly growth since the first quarter of 2009 at the height of the global financial crisis and below economists’ expectations of 6.6%. Chinese firms are getting concerned about the loss of growth momentum for the first time in the past 40 years.

Managing costs appropriately is critical for businesses to survive an economic or activity downturn. Managers must consider the potential effects of the downturn and make resource adjustment decisions accordingly to minimize the adverse effects and position the business to emerge strongly when conditions improve. The object of this article is to highlight literature that analyzes cost behaviors across firms and to provide practical advice for managers of businesses in a downturn. This article may provide useful and timely suggestions for Chinese companies and managers to deal with and get prepared for business downturns.

It is important to recognize that costs result from deliberate resource commitment decisions by managers (Cooper and Kaplan 1992). “managers choose resource levels subject to various constraints, incentives, and biases …” and “cost behavior patterns arrive from managers decisions to commit resource is subject to context-specific constraints” (Banker et al, 2017). Therefore, costs are consequences of decisions that managers make, and cross behaviors are essentially manage his behaviours.

Fixed and variable costs

The traditional cost behavior model described in accounting textbooks assumes that costs are either fixed or variable. In the short run, fixed costs are constant and variable costs change in proportion to changes in the related level of total activity or volume of the cost driver. Therefore, according to this model, total costs of a business or a linear function of the cost drivers and the two types of costs and. Although activity-based costing (ABC) has refined the traditional cost modeled by identifying individual activities as the fundamental cost objects. It still assumes a linear relationship between activity levels and costs importantly, there is no active decision role for managers in the fixed and variable costs model.

The fact is that some cost changes are not strictly proportional to changes in activity because managers make deliberate decisions to adjust or retain resources. If the demand exceeds existing resource supply (resources are strained), then managers will increase the supply of resources to meet the increased demand. If, however, demand falls below the available resource supply (select resources exist) unused resource is will not be removed automatically. Managers must make decisions to adjust the resource is accordingly. For example, as sales and production grow, Additionally employees are hired to handle the additional volume; However, if the volume declines, these employees may not be laid off immediately. Because managers are likely to respond differently to strain than to slack, costs may rise more with increases in activity volume then they fall with decreases in activity.

Sticky costs

This asymmetry in cost behaviour between activity increases and decreases, labeled as cost stickiness (Anderson, Banker and Janakiraman, 2003), has been widely examined in the management accounting literature. Sticky costs occur because managers must make decisions to add or remove resource is. When sales increase, resources must be added to accommodate the increase. When sales decrease, slack resources must be managed – they don’t go away by themselves.

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