In our last video, we covered mixed costs and the concept
of the relevant range.
In this video, we're going to answer the question,
why should you care.
Understanding cost behavior helps
us to understand the risks that companies expose themselves to
by having different types of costs.
The best way to demonstrate this is to give a concrete example.
Let's look at printing the Toronto Star.
The Toronto Star is owned by Torstar Corporation.
Torstar Corporation in 1992 built a printing plant
located in Vaughan, Ontario.
The total cost of the plant, if that was our cost object,
would be a mixed cost.
Let's graph that.
We already know that mixed costs end up
having a level of fixed cost regardless
of their level of activity.
In this case, the level of activity
is the number of newspapers that were printed.
As long as those newspapers being printed
were within the relevant range, the fixed cost
would not change, even if they'd printed zero.
Torstar would also have a variable cost.
The variable cost would be made up
of things like the direct material
and the direct labor that was consumed
in the printing of the newspapers.
If we printed no newspapers, there
wouldn't be any direct material or direct labor.
This, in that case, is equal to the total cost of running
the printing plant in Vaughan.
What would happen if Torstar stopped
printing any newspapers so that their level of activity
went down to zero?
They would still have to fixed cost,
but their variable costs would be down to zero.
We know that even if they printed zero newspapers,
they would have to pay those fixed costs.
Fixed costs, therefore, increase the risk
that a company will incur.
Risk meaning the possibility that the company does not
produce enough revenue to cover all of the costs, both variable
and fixed.
How can we see this?
Assume that Torstar prints 1,000 newspapers.
The total cost of those newspapers
would be both the variable portion and the fixed portion.
But notice, if they produced zero newspapers,
they still have to incur 100% of the fixed costs.
That indicates that there is a risk involved
in running this business.
The risk is the possibility that the company's revenues, which
they produce through the sale of newspapers,
would not be enough in order to cover both the variable
and the fixed costs.
How could Torstar reduce their risk?
They could do so by reducing their fixed costs
or eliminating the fixed costs so that they only
have variable costs.
And that's exactly what Torstar did.
In July of 2016, Torstar closed their printing press
in Vaughan.
They contracted out 100% of their printing operations
to Transcontinental Printing, Canada's largest
commercial printing company.
What Torstar did was outsource the printing
of the Toronto Star to an outside supplier
of printing services.
The move to close the plant affected 220 full-time and 65
part0time employees.
That happened in July of 2016.
What would their costs have looked like immediately
after closing the plant?
They would have had two graphs.
For every newspaper printed, Transcontinental Printing
would charge Torstar.
But if there was zero newspapers printed,
they would charge them nothing.
Transcontinental was 100% of variable costs.
As the number of printed newspapers increased,
the cost would increase.
But if there was a reduction in the number of newspapers
printed, it would reduce the total variable costs.
The level of activity would directly
impact the total variable costs.
But what about the closed printing plant?
Regardless of the level of activity,
the plant, even though it produced nothing,
still had fixed costs.
It doesn't look like Torstar actually changed their position
at all, because they still had fixed costs
with the shuttered plant and they still
had variable cost through Transcontinental Printing.
Their level of risk had not changed.
However, what would happen if Torstar sold their plant?
Which is just what they did in September of 2016.
They signed the deal to sell the printing
plant to an unidentified buyer for $54.25 million.
After the sale, the cost of the printing plant
went down to zero.
In that case, after the sale of the printing plant,
the only cost incurred for printing the Toronto Star
was the variable cost.
Torstar Corporation had effectively reduced their risk.
If their sales of printed newspapers went down to zero,
they would pay zero.
Previously, when they had fixed costs,
they would have been stuck with continuing
to pay those fixed costs, regardless
of the number of newspapers produced.
Torstar had reduced their risk by converting a mixed cost
into a pure variable cost.
It reduces their risk because, if there
was a reduction in the number of newspapers printed and sold,
the total cost to print those newspapers would also reduce.
There is no further fixed costs which
would be paid, regardless of the level of activity.
This also demonstrates a very important concept.
Variable costs can be changed in the short-term.
Changes to fixed costs, however, is a long-term decision.
Thank you so much for joining me and learning all
about cost behavior patterns.
See you in the next video.