With me living in the South now for six years, it does make intuitive sense that Bruster’s and Ben and Jerry’s would be open all year round selling ice cream. However, what about Syracuse, NY? Minneapolis? Detroit? With sub-freezing temperatures a regular occurrence up North, why on earth would Ben and Jerry’s remain open in those areas? The answer lies within the concepts of sunk cost and short-run cost production theory.
Sunk cost is a key, but often misunderstood, concept by business executives. Sunk cost is a cost that exists and cannot be recovered. There are too many instances where cost/benefit analysis go awry because firms incorrectly include sunk cost into their analysis.
As for short-run cost production, we need to distinguish between the short-run and the long-run. The short-run means that there are certain costs that the firm cannot avoid, such as the lease payment. Lease agreements can last for a specific period of time ranging from one year up to 30 years or more. A firm reaches the long-run when their lease runs out and they can either renew or not renew. In referring back to the ice cream, we will be assuming that they are in the short-run and deciding whether to stay open or shut down temporarily due to less than ideal weather conditions for eating ice cream.
Let’s assume there’s a hypothetical ice cream parlor, named Isis Ice Cream, is operating in Syracuse, NY. While recognizing that ice cream is not a perfectly competitive market, where products are identical and there are numerous buyers and sellers, it is close enough for this analysis. Their projected monthly revenues for December are $10,000 where they sell 2,500 cones at a price of $4 a cone. Isis must pay rent for the facility and insurance, which adds up to fixed costs of $2,000 a month. In order to make and serve ice cream, they must pay variable costs of $9,000 to hire workers and operate the freezer, ice cream maker and other supplies needed to produce ice cream.
The goal of Isis is to maximize profits which occur when total revenues exceed total costs. However in this example, Isis is losing $1,000 ($10,000 – $11,000) due to less customers wanting to buy ice cream in the frigid conditions of Syracuse, NY. We know this because total revenues of $10,000 is less than total costs of $11,000 (fixed cost + variable cost). The inclination would be to close their shop in December and that would be the case if they incorrectly include sunk costs.
When making this decision, Isis should disregard the lease payment and insurance cost ($2,000) and only focus on the variable cost, which are labor and operational cost. When looking at just variable cost, we see that staying open in February will yield revenues that will exceed variable cost by $1,000. That is important because comparing the financial results of closing in December or remaining open will yield differing results.
Isis could close in December, which means giving up the $10,000 in revenues. While that would save the firm in having to pay labor costs and utilities, they still have to pay the lease and insurance. Therefore, they would lose more. Their economic losses would now by $2,000 ($0 – $2,000). By ignoring sunk costs, their owner is better off because their losses are less.
Based on that example, we can draw this conclusion. When making a decision on whether to open or close a seasonal business, only consider your variable cost. As long as one can earn revenues that equal or exceed your labor and operational cost, continue operating. If your revenues do not exceed those costs, then it makes sense to shut down temporarily. Let us change one of those assumptions for you to see that.
Assume due to market conditions, such as declining income or increased competition from yogurt competitors, the price of ice cream cones fall from $4 to $3. Notice how revenues change. Now Isis sells 2,500 cones at $3 a cone, which will yield revenues of $7,500. That can no longer cover their operational cost and now losses balloon to $3,500. Since this loss would be more than the lease and insurance payments, it would be rational to close their shop.
So the next time you see Ben and Jerry’s open during blizzard conditions, do not automatically assume that they do not know what they are doing. They just might be accurately excluding their sunk cost.