The problem of Negative Fixed Costs Essay

“This is crazy!” exclaimed the production supervisor as he reviewed the work of his new assistant. “You and that computer are telling me that my fixed costs are negative! Tell me, how did you get these negative fixed costs, and what am I supposed to do with them?”.

Explain to the supervisor the meaning of the “negative fixed costs” and what can be done with them.

Solution

By definition, fixed costs are the company’s expenses that do not increase or decrease depending on the change in the volume of goods or services sold. These costs have to be paid by the company in any case and represent one of two major cost components (along with variable costs). Fixed costs influence the company’s break-even point and are taken into account during strategic decision-making such as production volume, pricing, marketing of new products, etc. Fixed costs are typically time-driven. Besides fixed and variable costs, there are two other types that involve the concept of fixed costs: mixed or semi-variable costs that combine elements of fixed and variable costs (e.g. electricity is spent both on basic lighting which is typically a fixed cost, and on producing goods or services which is typically a variable cost) and step costs (costs that remain constant for a certain level of activity but increase to the next constant level when the volume of activity increases) (Dyckman et al., 2015).

If the fixed costs are reported as negative, this is an indication that either the type of fixed costs used in the accounting documentation was determined not exactly (i.e. there are step costs instead of fixed costs, or parts of mixed costs were incorrectly labeled as variable costs whereas they are fixed costs) or that the data used for assessing fixed costs are not representative. There might be several reasons why negative fixed costs emerged in accounting operations.

If mixed costs were incorrectly divided into fixed and variable parts or some factor influenced this division, it might happen that with the increase in production the “remaining” part of the mixed cost became negative. For example, let us assume that the total cost of a certain factor was Z, and its variable part was determined as X*n, where n was the volume of production and X was the variable part of the factor’s price per unit. Then the fixed part of mixed costs was determined as Z – X*n. If at some point the change in the volume of production or some other factor made X value lower than before (for example, advanced machine capacity allowed to manufacture more units using the same volume of electricity as before), then the fixed costs calculated by the formula above would become negative. This situation is a sign that the approach to calculating fixed costs should be reconsidered, and more precise values of fixed and variable costs should be determined. In particular, it is necessary to re-assess the types of fixed costs and the associated expenses.

Another related situation when negative fixed costs might emerge is the case when high-low cost estimation is used with high and low-cost activity levels that are not representative of the current situation. The high-low method uses the difference in total costs divided by the difference in activity level to determine the variable costs per unit, and if the high and low activity levels are not exactly relevant to the current situation, fixed costs might turn out to be negative. In this case, it is necessary to review costs and to re-determine the high and low-cost activity levels to make them relevant to the situation. Another way to resolve this situation is to use a different costing method since the high-low method is often perceived as poorly reliable because of its generic approach (Dyckman et al., 2015).

The issue with negative fixed costs might also emerge in the case when least-squares regression is used to predict variable and fixed costs. Again, the situation means that the data entered into regression analysis were not exactly relevant to the current situation, and it is necessary to review the data and repeat the analysis. If one variable is used for least-squares regression, it might be possible to include several factors that might influence variable costs in the analysis and to perform multiple regression analysis.

There also exist factors that are directly not related to accounting procedures that might have influenced the results of calculating fixed costs. If pricing or technology has changed in the reporting period, these changes might affect cost calculations (Dyckman et al., 2015). In this case, it is necessary to reconsider the assumptions used for calculating the costs and to update the information used for costing. Another potential issue is an incorrect or incomplete selection of activity cost drivers: perhaps, one of the factors used for determining activity costs should not be taken into account for this activity. Furthermore, there might be a time gap between the activity and the related costs: if the payments are done in other periods, cost estimates might associate certain activities with not relevant costs. In each of these situations, it is necessary to perform structural analysis, determine the assumption or procedure that leads to negative fixed costs, and to re-calculate the costs.

CVP Analysis Using Published Financial Statements

Condensed data in thousands of dollars (000) from Netflix’s 2009 and 2010 income statements follow.

Required.

a. Develop a cost-estimation equation for Netflix’s annual cost of revenues and operating expenses

b. Determine Netflix’s annual break-even point

c. Predict operating profit for 2011, assuming 2011 sales of $3,204,577 thousand.

d. Identify the assumptions required to use the equations and amounts computed above.

Solution.

a. It is possible to develop a cost-estimation equation for Netflix using the high-low method. In this method, the cost-estimation equation is represented as y = A + Bx, where A denotes fixed costs, B denotes variable costs per 1 unit (of the independent variable), x is the independent variable and y is the dependent variable. In the current case, the dependent variable is “total cost of revenues and operating expenses” (expressed as a positive amount), and the independent variable is “revenues”. Let us denote the values of the independent and the dependent variable in 2009 as x1 and y1 respectively, and the values of the independent and the dependent variable in 2010 as x2 and y2 respectively.

According to the high-low method, the value of the variable cost per unit is determined as:

B = (y2 – y1) / (x2 – x1), and the value of fixed costs is calculated as A = y2 – Bx2 = y1 – Bx1 (Dyckman et al., 2015). The calculations below will be presented in a rounded form, but the exact values will be used for further calculations in Excel (so the calculated value of 1.666666667 will be used as such in further calculations but presented as 1.67 in the document).

In the current case, variable costs are: B = (1,878,984 – 1,478,330) / (2,162,625 – 1,670,269) / = 400,654 / 492,356 = $0.81 (per 1 dollar of sales). Fixed costs are: A = y2 – Bx2 = 1,878,984 – 0.81*2,162,625 = 1,878,984 – 1,759,833 = 119,151. Therefore, the cost-estimation equation for Netflix is the following:

Total cost of revenues and operating expenses = $119,151 + $0.81 * Revenues (where revenues are expressed in thousands).

b. The break-even point is achieved when annual profit (operating income) equals zero. In the current case, profit is determined as the difference between revenues and total cost of revenues and operating expenses. Using the previously developed cost-estimation equation, it is possible to express profit as the following function:

Operating Income = Revenues – (119,151 + 0.81 * Revenues) = Revenues – 119,151 – 0.81 * Revenues = 0.19*Revenues – 119,151.

The break-even point will be achieved when Operating Income = 0, or 0.19*Revenues – 119,151 = 0. Revenues = 119,151 / 0.19 = 639,731.8 (thousands). The break-even sales volume for Netflix therefore equals to $639,731,800.

c. Using the cost-estimation equation, it is possible to predict operating profit for the year 2011 knowing the sales. The equation for profit (operating income) was developed above.

Operating Income = 0.19*Revenues – 119,151. In the current case, Operating Income = 0.19*Revenues – 119,151 = 0.19 * 3,204,577 – 119,151 = 596,857 – 119,151 = 477,706. Thus, the profit for 2011 is expected to equal $477,706 (thousands).

d. For high-low calculations to be valid, it is necessary to use representative high-activity and low-activity periods for estimating fixed and variable costs. Therefore, the calculations are valid under the assumption that the values for Netflix’s activity in 2009 are representative of a low-activity period and the values for Netflix’s activity in 2010 are representative of a high-activity period. Furthermore, for these equations to be valid, it is necessary to assume that there were no structural changes in Netflix’s cost during these periods (i.e. that there were no technology changes, level changes for a step or mixed costs, etc.), and there will be no such changes in 2011 (for part C to be valid).

References

Dyckman, T.R. et al. (2012). Financial and Managerial Accounting for Decision Makers. Cambridge Business Publishers.