Have you ever driven by a poorly maintained business facility and wondered why the owner doesn’t either fix up the property or go out of business? The somewhat surprising answer is that it may be unprofitable to improve the facility, yet profitable to continue to operate it as it deteriorates. Seeing why will aid your understanding of fixed cost, variable cost, profit-maximization, and shutdown points. Consider the hypothetical story of the Highway View Inn, a one-story motel on Old Highway North, Any Town, USA. The owner of Highway View built the motel on the basis of traffic patterns and competition that existed several decades ago. As interstate highways were built, Highway View found itself located on a relatively vacant stretch of road. Also, it faced greatly heightened competition from new so-called "chain" motels located closer to the interstate highway. In a typical early year Highway View had annual total revenue of $300,000, annual fixed cost of $80,000, and annual variable cost of $130,000. Its profit was $90,000 (= $300,000 - $210,000). But beginning a decade or so ago annual total revenue fell to $180,000, compared to fixed and variable costs of $80,000 and $110,000, respectively. In that year Highway View had a $10,000 (= $190,000 - $180,000) loss. Why did it stay open? The answer is that the motel’s $180,000 of total revenue was sufficient to cover the $110,000 of variable cost and contribute $70,000 to the $80,000 payment of fixed cost. By staying open Highway View lost $10,000 instead of the $80,000 (equal to its fixed cost) it would have lost if it had shut down. Highway View’s total revenue of $180,000, however, did not cover its total cost of $190,000. It therefore realized that it would have to shut down in the long run. But rather than immediately close its doors, it decided to lower its total cost by reducing maintenance. In effect, it decided to allow its property to deteriorate as a way to squeeze out some more profits before shutting down. This regained profitability is temporary, however, because deterioration of the motel structure eventually results in lower occupancy rates and room rates, and therefore lower total revenue. Highway View knows that its total revenue sooner or later will fall below its total cost, even with an annual maintenance expense of zero. When that situation occurs, it is prepared to close its operations, tear down the motel, and sell its vacant property. But in the meantime, Highway View is open, deteriorating, and profitable. In general, it is a good business practice to maintain and improve one’s property. But, as we have seen, there are interesting exceptions.

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