Legacy costs are expenses that are incurred by an organization for obligations related to previous business activities but are still being paid for in the present. These are typically commitments made to employees, such as health insurance, life insurance, and pension benefits, which extend into the employees’ retirement, long after they have ceased contributing to the company’s revenue.
Legacy costs can present a significant financial burden for businesses, particularly those in older industries that have a large number of retired employees relative to active employees, like the automobile manufacturing and coal mining industries. High legacy costs can put these companies at a competitive disadvantage compared to newer firms that do not have the same level of commitment to retired employees.
In addition to employee-related benefits, legacy costs can also include ongoing costs related to environmental cleanup, maintenance and deactivation of old facilities, or long-term debt incurred from past activities.
It’s important for organizations to effectively manage their legacy costs, as these costs can take up a substantial portion of a company’s resources and potentially affect its profitability and competitiveness.
Example of Legacy Costs
Let’s consider an example using a hypothetical automobile manufacturing company.
This company has been in operation for over 50 years and has a large number of retired employees. In its early years, the company promised generous retirement benefits to its employees as part of their employment contracts, including pensions and healthcare benefits that extend into retirement.
Now, 50 years later, the company has many retired employees who are receiving these benefits. These ongoing pension payments and healthcare costs for retired employees are considered legacy costs.
Assuming the company has 5,000 retirees and pays an average of $1,000 a month for pension and healthcare benefits per retiree, this would amount to a legacy cost of $5,000,000 per month, or $60,000,000 per year.
These legacy costs can create a significant financial burden for the company. If the company’s sales decline, or if it faces increased competition from newer automobile manufacturers that don’t have these legacy costs (because they haven’t been in operation long enough to have a large number of retirees), these legacy costs could become a serious threat to the company’s financial stability.
This example shows why it’s crucial for companies to plan and account for these legacy costs in their long-term financial planning. It’s also one of the reasons some companies have moved away from defined benefit pension plans (which promise a certain payout) to defined contribution plans (like 401(k)s, which specify how much will be contributed to the plan but don’t guarantee a certain payout), in order to limit their legacy cost liabilities.