Lesson 5 of 7
What a company can stop paying
Which costs fall with volume and which do not, where each is disclosed, and why the split matters more than the level of any margin in a bad year.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- No income statement separates fixed from variable costs, so the split has to be estimated from how each line moved across filed years.
- Depreciation, research spending and much of the administrative base do not fall with volume; materials and distribution largely do.
- The split, not the level of any margin, is what decides the shape of a bad year.
An income statement reports costs by function or by nature. It never reports them by behaviour, which is the classification this question needs.
Cost of revenue against revenue at one filer, four filed fiscal years
- Revenue
- Cost of revenue
Show the numbers
| Revenue | Cost of revenue | |
|---|---|---|
| FY22 | 30,758$m | 16,860$m |
| FY23 | 15,540$m | 16,956$m |
| FY24 | 25,111$m | 19,498$m |
| FY25 | 37,378$m | 22,505$m |
Reading the chart before the words
Between fiscal 2022 and fiscal 2023 at the filer above, revenue fell 49.5 percent, from 30,758 million dollars to 15,540 million. Cost of revenue over the same two years rose, from 16,860 million to 16,956 million.
Cost of revenue exceeded revenue in fiscal 2023 by 1,416 million dollars, which is a gross loss: the company sold its output for less than the cost the accounts assign to producing it.
A cost line that does not move at all when volume halves is not a variable cost in any useful sense, whatever it is called.
How to estimate the split
Take four or more filed years, plot each cost line against revenue, and look at how far each one moved. A line that tracks revenue closely is behaving variably. A line that barely moves is behaving fixedly. A line that moves in the opposite direction contains something else, which is worth finding.
This is a rough method and it is the only one available from published statements. It is confounded by anything else that changed over the same years: a price change, an acquisition, a restructuring, a change in what is included in the line.
What is usually fixed
Depreciation and amortisation, which is the subject of the next lesson and is the largest fixed cost at a capital-intensive company. Research spending, which companies rarely cut in proportion to a downturn because the projects have multi-year horizons. Much of the administrative base. And any minimum payment under a take-or-pay contract, which the balance sheet course covers.
What is usually variable
Materials and components. Distribution and freight. Sales commission. Volume related manufacturing labour, though less than readers expect, since skilled staff are expensive to lose and expensive to replace.
The habit
Before writing any condition on a margin, ask what share of the cost behind it is fixed. A gross margin condition at a company where half of cost of revenue is depreciation is really a condition on volume, and it will move further and faster than the reader who wrote it expects.
Check yourself
Why can the fixed and variable split not be read directly from an income statement?
- Because companies do not disclose costs
- Because costs are reported by function or by nature, never by behaviour
- Because the split changes each year
Show the answer
Answer: B.
The estimate has to come from plotting each line against revenue across several filed years, which is rough and confounded by anything else that changed.Revenue fell 49.5 percent while cost of revenue rose 0.6 percent. What does that tell you about the line?
- That the company raised prices
- That a large part of it does not behave variably, whatever the line is called
- That inventory was written down
Show the answer
Answer: B.
The depreciation charge inside that line rose nine percent over the same two years and reached 49.9 percent of revenue.Why is a gross margin condition at such a company really a condition on volume?
- Because gross margin is not disclosed quarterly
- Because a large fixed charge inside cost of revenue means the margin moves with volume rather than with pricing or efficiency
- Because inventory costing assumptions change
Show the answer
Answer: B.
The condition will move further and faster than the reader who wrote it expects, which is worth knowing before the level is chosen.Sources
- Micron Technology, Inc., annual reports on Form 10-K for fiscal years 2022 through 2025, for revenue, cost of revenue and depreciation and amortisation: fiscal 2022 accession 0000723125-22-000048; fiscal 2023 accession 0000723125-23-000054; fiscal 2024 accession 0000723125-24-000027; fiscal 2025 accession 0000723125-25-000028.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- Estimating cost behaviour from filed years is confounded by everything else that changed over those years, including prices, product mix, acquisitions and restructuring. It gives a direction rather than a coefficient.
- The depreciation charge is not separately disclosed within cost of revenue. The comparison above places the total charge beside that line and does not claim all of it sits there.
- Nothing here is a view on Micron or on any security.