Cost stickiness

What Is Cost Stickiness?

Cost stickiness is an accounting phenomenon where a company's costs increase significantly when activity levels rise but decrease by a much smaller amount when activity levels fall by an equivalent proportion. This asymmetric cost behavior challenges the traditional assumption in managerial accounting that costs respond symmetrically to changes in activity, meaning they would increase and decrease at similar rates. The concept highlights how certain expenses, particularly selling, general, and administrative (SG&A) expenses, tend to "stick" at higher levels even when business activity declines, impacting overall profitability.

History and Origin

The concept of cost stickiness gained prominence with the seminal academic paper "Are Selling, General, and Administrative Costs 'Sticky'?" published in the Journal of Accounting Research in 2003 by Mark C. Anderson, Rajiv D. Banker, and Surya N. Janakiraman. The researchers investigated the behavior of SG&A costs over two decades for thousands of firms. Their findings indicated that, on average, these costs increased by 0.55% for every 1% increase in sales but decreased by only 0.35% for every 1% decrease in sales⁸, ⁹. This empirical evidence challenged the long-held assumption in cost accounting that expenses adjust proportionately to changes in sales or production volume⁷.

The authors attributed this asymmetric behavior partly to managerial decision-making. Managers, faced with a downturn, may hesitate to reduce resources like employees or facilities, hoping for a quick recovery or wanting to avoid the costs associated with layoffs and rehiring, leading to unutilized capacity⁶.

Key Takeaways

Cost stickiness describes the phenomenon where costs rise more with activity increases than they fall with equivalent activity decreases.
It primarily affects discretionary costs such as selling, general, and administrative (SG&A) expenses, rather than direct production costs.
Managerial reluctance to cut resources during downturns, driven by optimism or adjustment costs, is a primary cause.
This asymmetric cost behavior can negatively impact a company's profitability and financial flexibility during periods of declining revenue.
Understanding cost stickiness is crucial for effective budgeting and strategic cost management.

Interpreting Cost Stickiness

Interpreting cost stickiness involves understanding its implications for a company's financial health and operational efficiency. When costs are sticky, a decline in sales or production volume does not lead to a proportional reduction in expenses, resulting in shrinking profit margins. This can be particularly problematic during economic downturns, as it implies that companies cannot quickly adapt their cost structures to falling demand.

Analysts often observe this phenomenon by examining the relationship between changes in sales and changes in various expense categories, especially SG&A. A high degree of cost stickiness can indicate that a company has less operating leverage than traditionally assumed, meaning its profits are more sensitive to sales declines. Conversely, a company that can manage its sticky costs effectively may demonstrate greater resilience in volatile market conditions.

Hypothetical Example

Consider "Alpha Manufacturing," a company producing widgets. In Year 1, Alpha produces and sells 100,000 widgets, incurring SG&A overhead costs of $$500,000. These costs include salaries for sales staff, administrative personnel, and marketing expenses.

In Year 2, due to a market slowdown, Alpha's sales volume decreases by 20% to 80,000 widgets. If costs were perfectly flexible, one might expect SG&A costs to decrease proportionally, perhaps to $$400,000 (a 20% reduction).

However, due to cost stickiness, Alpha's management might be hesitant to lay off experienced sales or administrative staff immediately, hoping for a rebound. They might reduce some discretionary spending like advertising, but core salaries remain largely unchanged. As a result, Alpha's SG&A costs only decrease by, say, 5% to $$475,000.

In Year 3, the market recovers, and sales increase by 20% back to 100,000 widgets. SG&A costs might increase by 15% to $546,250 (from$ 475,000). This illustrates that the percentage increase in costs when sales rise (15%) is greater than the percentage decrease when sales fall by an equivalent amount (5%), demonstrating cost stickiness.

Practical Applications

Cost stickiness has several practical applications in corporate finance and financial analysis:

Budgeting and Forecasting: Businesses must account for cost stickiness when preparing budgets and financial forecasts. Assuming costs will fall proportionally with revenue can lead to overly optimistic profit projections during downturns. Recognizing sticky costs allows for more realistic budgeting and resource allocation.
Strategic Cost Management: Understanding which costs are sticky helps management identify areas where proactive cost management strategies are needed. This might involve renegotiating contracts, implementing flexible staffing models, or adopting activity-based costing to better align costs with activities. Recent economic discussions highlight the challenge companies face in reducing operational expenses despite slowing demand, a clear indication of cost stickiness in action⁵.
Investment Analysis: Investors and analysts consider cost stickiness when evaluating a company's financial health and resilience. Companies with lower cost stickiness in their key expense categories may be viewed as more agile and better positioned to navigate economic fluctuations.
Performance Evaluation: Managers' performance evaluations can be distorted if cost stickiness is not considered. A manager might be praised for cost control during growth but unfairly criticized for not reducing costs sufficiently during a downturn if the inherent stickiness of those costs is overlooked.

Limitations and Criticisms

While cost stickiness is a widely recognized phenomenon, it has certain limitations and faces some criticisms. One key limitation is that the degree of stickiness can vary significantly across industries, companies, and even different types of costs within the same company. For instance, companies in industries with high fixed costs or those that benefit from significant economies of scale might exhibit different patterns of stickiness compared to service-oriented businesses.

Furthermore, some research suggests that cost stickiness might not always be a result of managerial discretion or inefficiency. Instead, it could be influenced by factors such as:

Adjustment Costs: The actual costs associated with reducing resources (e.g., severance pay for layoffs, early termination fees for leases) can outweigh the benefits of immediate cost reductions, making managers hesitant to act swiftly⁴.
Future Expectations: If managers anticipate a quick rebound in demand, they may deliberately maintain resources to avoid future rehiring and retraining costs, viewing the current excess capacity as temporary.
Information Asymmetry: Managers may possess better information about the permanence of a demand shock than external stakeholders, leading to decisions that appear "sticky" but are rational given their internal knowledge³.
Measurement Challenges: Accurately attributing cost changes solely to activity changes can be complex, as other factors like inflation, technological advancements, or regulatory changes can also influence cost structures. Some studies have explored alternative explanations for observed cost behavior, suggesting that what appears as stickiness might sometimes be explained by other organizational or economic factors².

The phenomenon is also not universally present across all contexts, with research sometimes finding variations in the degree to which firms adjust their costs symmetrically, depending on specific economic conditions or firm characteristics.

Cost Stickiness vs. Cost Flexibility

Cost stickiness and cost flexibility represent opposing ends of the spectrum in how a company's expenses react to changes in activity levels. Fixed costs and variable costs are the foundation of understanding cost behavior.

Cost Stickiness: This refers to the asymmetric behavior where costs increase substantially when activity rises but decrease less proportionally when activity falls. It implies a degree of rigidity in downward cost adjustments. For example, salaries for essential administrative staff are often sticky; they rise as a business grows but are difficult to cut even if revenue declines. This makes it hard for companies to reduce costs quickly when demand slows¹.
Cost Flexibility: This describes the ability of a company's costs to quickly and proportionally adjust to changes in activity levels, both up and down. A highly flexible cost structure means that expenses, particularly variable costs, can be easily scaled back when sales decline, thereby protecting profit margins. For instance, the cost of raw materials directly tied to production is typically very flexible, decreasing immediately when production volume drops.

The primary confusion between the two arises when assuming that all costs, especially those typically classified as variable, will exhibit perfect flexibility. Cost stickiness highlights that many real-world costs, particularly those with a discretionary component, do not behave with such perfect symmetry, creating a challenge for businesses aiming for maximum efficiency.

FAQs

What types of costs are most likely to be sticky?

Costs most prone to stickiness are often those that involve committed resources that are difficult or expensive to divest quickly. These commonly include selling, general, and administrative (SG&A) expenses such as employee salaries, rent for office space, marketing expenditures, and certain IT infrastructure costs. Unlike variable costs like raw materials, reducing these expenses often requires difficult managerial decisions or incurs significant adjustment costs.

Why do companies experience cost stickiness?

Companies experience cost stickiness for several reasons. Managers might be optimistic about future sales recovery and thus reluctant to shed resources, fearing the cost and disruption of rehiring. There are also practical "adjustment costs" like severance pay or lease termination fees that make immediate cost cutting uneconomical. Additionally, some costs represent committed investments in capacity that cannot be easily scaled down in the short term, regardless of activity levels.

How does cost stickiness affect a company's financial performance?

Cost stickiness directly impacts a company's profitability, especially during periods of declining revenue or activity. When costs do not fall as rapidly as sales, profit margins shrink, and the company's operating leverage can be negatively affected. This makes it harder for the company to remain profitable or even break even during economic downturns, potentially leading to cash flow problems or a need for external financing.

Can cost stickiness be mitigated?

Yes, companies can employ strategies to mitigate cost stickiness. These include implementing more flexible staffing models (e.g., increased use of temporary staff), outsourcing non-core functions, regularly reviewing and negotiating supplier contracts, and adopting more rigorous cost management and budgeting practices. Focusing on variable compensation structures, where appropriate, can also help align costs more closely with revenue.