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Chapter 11: Problem 7

(Related to the Apply the Concept on page 376) Small business owner Jay Goltz described several decisions he made to reduce the fixed costs of his businesses, including replacing halogen lamps with LED lamps. Goltz noted, "I'm guessing that many business owners could save a lot more than pennies on their fixed costs, and those savings ... fall right to the bottom line." a. Why are the costs of electricity used to power the lights used in Mr. Goltz's businesses fixed costs? b. Explain why Goltz wrote that reducing fixed costs results in savings that "fall right to the bottom line."

Short Answer

Expert verified
The costs of electricity used to light Mr. Goltz's businesses are considered fixed costs because they are incurred irrespective of changes in the level of output. Mr. Goltz states that reducing fixed cost results in savings that 'fall right to the bottom line' because reduced fixed costs translate to lower total expenses. Since the bottom line (net income) is calculated by subtracting total expenses from total revenue, lowering total costs directly improves the company’s bottom line.

Step by step solution

01

Understanding Fixed Costs

Fixed costs are those costs that a business incurs regardless of the level of goods or services it produces. They are named so because they remain unchanged even when there are fluctuations in the level of output. This holds true for the cost of electricity used to power the lights in businesses. These costs are incurred whether the businesses are running at full, half, or minimal capacity. Thus, electricity costs are considered fixed costs.
02

Understanding the Bottom Line

The 'bottom line' in business refers to the net income or earnings, which is calculated by subtracting all expenses, including taxes and cost of goods sold, from the total revenue. Anything that increases revenue or reduces expenditures will improve the bottom line, that is, increase the net income or profit.
03

Linking Reduction of Fixed Costs to the Bottom Line

When Mr. Goltz reduces his fixed costs, such as the cost of electricity by switching to LED lamps, he is effectively reducing his total costs of running the businesses. Since fixed costs are a part of total expenses, reducing fixed costs will lower the total expenses. As a result, it directly increases the bottom line as the net income is given by the difference between total revenue and total costs. Therefore, the savings from reduced fixed costs 'fall right to the bottom line'.

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