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Concepts in Action Fixed Costs, Variable Costs, and the Future of Radio Building up too much fixed costs can be hazardous to a company's health. Because fixed costs, unlike variable costs, do not automatically decrease as volume declines, companies with too much fixed costs can lose a considerable amount of money during lean times. Sirius XM, the satellite radio broadcaster, learned this lesson the hard way. To begin broadcasting in 2001, both Sirius Satellite Radio and XM Satellite Radio-the two companies now comprising Sirius XM-spent billions of dollars on broadcasting licenses, space satel lites, and other technology infrastructure. Once operational, the companies also spent billions on other fixed items such as program- ming and content (including Howard Stern and Major League Baseball), satellite transmission, and R&D. In contrast, variable costs were minimal, consisting mainly of artist-royalty fees and cus- comer service and billing. In effect, this created a business model with a high operating leverage-that is, the companies' cost struc- ture had a very significant proportion of fixed costs. As such, prof- itability could only be achieved by amassing millions of paid subscribers and selling advertising. The competitive disadvantage of this highly-leveraged business model was nearly disastrous. Despite amassing more than 14 million subscribers, over the years Sirius and XM rang up $3 billion in debt and tallied cumulative operating losses in excess of $10 billion. Operating leverage, and the threat of bankruptcy, forced the merger of Sirius and XM in 2007, and since then the combined entity has struggled to cut costs, refinance its sizable debt, and reap the profits from over 18 million monthly subscribers. While satellite radio has struggled under the weight of too much fixed cost, Internet radio had the opposite problem-too much variable costs. But "How?" you ask. Don't variable costs only increase as revenues increase? Yes, but if the revenue earned is less than the variable cost, an increase in revenue can lead to bankruptcy. This is almost what happened to Pandora, the Internet radio service. Pandora launched in 2005 with only $9.3 million in venture capital. Available free over the Internet, Pandora earned revenue in three ways: advertising on its Web site, subscription fees from users who wanted to opt-out of advertising, and affiliate fees from iTunes and Amazon.com. Pandora had low fixed costs but high variable costs for streaming and performance royalties. Over time, as Pandora's popular service attracted millions of loyal listeners, its costs for performance royalties-set by the Copyright Royalty Board on a per song basis-far exceeded its revenues from advertising and subscriptions. As a result, even though royalty rates were only a fraction of a cent, Pandora lost more and more money each time it played another song! In 2009, Pandora avoided bankruptcy by renegotiating a lower per-song royalty rate in exchange for at least 25% of its U.S. revenue annually. Further, Pandora began charging its most frequent users a small fee and also started increasing its advertising revenue. Sommers: Birger, Jon. 2009. Mel Karmazian fights to rescue Sirius. Forrane, March 16; Clifford, Stephanie. 2007. Pandora's long strange mip. lee , October 1; Pandora: Royalnes kill the web radio star! (A). Harvard Business School Case No. 9-310-026; Satellite radio: An industry case study. Kellogg School of Management, Northwestern University. Case No. 5-206-285; XM satellite radio (A). Harvard Business School Cause No. 9:504-009