The downward demand spiral for a company is the continuing reduction in the demand for its products that occurs when competitor prices are not met; as demand drops further, higher and higher unit costs produced by costing systems based on normal and master-budget capacity utilization result in greater reluctance to meet competitors’ prices.
The easiest way to understand the downward demand spiral is with an example. Assume Stassen uses master-budget capacity utilization of 8,000 units for product costing in 2020. The resulting manufacturing cost is $335 per unit Assume that in December 2019, a competitor offers to supply a major customer of Stassen (a customer who was expected to purchase 2,000 units in 2020) telescopes at $300 per unit. The Stassen manager doesn’t want to show a loss on the account and wants to recoup all costs in the long run, so the manager declines to match the competitor’s price. The account is lost. The loss of the customer means budgeted fixed manufacturing costs of $1,080,000 will now be spread over the remaining master-budget volume of 6,000 units at a rate of
Suppose yet another Stassen customer, who also accounts for 2,000 units of budgeted volume, receives a bid from a competitor at a price of $350 per unit. The Stassen manager compares this bid with his revised unit cost of and declines to match the competition, and the account is lost. Planned output would shrink further to 4,000 units. Budgeted fixed manufacturing cost per unit for the remaining 4,000 telescopes would now be The following table shows the effect of spreading fixed manufacturing costs over a shrinking level of master-budget capacity utilization:
Details of the table are as follows:
Master-budget capacity utilization denominator level (in units): 8,000
Budgeted variable manufacturing cost per unit: $200
Budgeted fixed manufacturing cost per unit (divide $1,080,000 by the number of units): $135
Budgeted total manufacturing cost per unit (sum of variable and fixed costs): $335
Budgeted variable manufacturing cost per unit: $200
Budgeted fixed manufacturing cost per unit (divide 1,080,000 by the number of units): $360
Budgeted total manufacturing cost per unit (sum of variable and fixed costs): $560.
Practical capacity, by contrast, is a stable measure. The use of practical capacity as the denominator to calculate budgeted fixed manufacturing cost per unit avoids the recalculation of unit costs when expected demand levels change because the fixed cost rate is calculated based on capacity available rather than capacity used to meet demand. Managers who use reported unit costs in a mechanical way to set prices are less likely to promote a downward demand spiral when they use practical capacity than when they use normal capacity utilization or master-budget capacity utilization.
Using practical capacity as the denominator level also gives the manager a more accurate idea of the resources needed and used to produce a unit when the cost of unused capacity is excluded. As discussed earlier, the cost of manufacturing resources supplied to produce a telescope is $290 ($200 variable manufacturing cost per unit plus $90 fixed manufacturing cost per unit). This cost is lower than the prices Stassen’s competitors offer and would have correctly led the manager to match the prices and retain the accounts (assuming for purposes of this discussion that Stassen has no other costs). If, however, the prices competitors offered were lower than $290 per unit, the Stassen manager would not recover the cost of resources used to supply telescopes. This would signal to the manager that Stassen was noncompetitive even if it had no unused capacity. The only way for Stassen to be profitable and retain customers in the long run would be to reduce its manufacturing cost per unit.
The downward demand spiral is currently at work in the traditional landline phone industry. As more telephone customers shift services to wireless or Internet-based options, Verizon and AT&T, the two largest telephone service providers in the United States, are reducing their focus on providing copper-wire telephone service to homes and business. As AT&T told the U.S. Federal Communications Commission, “The business model for legacy phone services is in a death spiral.” Concepts in Action: Can ESPN Avoid the Cord-Cutting “Death Spiral”? illustrates a similar phenomenon affecting cable networks.
