Posted: November 8th, 2023
Fixed and Variable Costs: Relevance in Accounting and Decision Making
Fixed and Variable Costs: Relevance in Accounting and Decision Making
For any business to perform any cost-volume-profit analysis, it must be able to understand some of the basic cost behaviours and techniques. Companies and accountants will use the term ‘cost’ differently depending on how they intend to employ the cost information. As a result, there are different classifications of costs, including fixed and variable costs. Having a comprehensive understanding of the different cost categories and how they apply is essential in managerial accounting. Any conversation concerning cost accounting starts with conveying that costs are categorized in three ways: fixed, variable, and mixed. Costs that do not fit into any of the three classes are perceived as hybrid, and can only be assessed in advanced accounting courses. Since variable and fixed costs constitute the foundation of other classifications, understanding where a cost lie becomes key to assembling accurate financial statements.
Fixed and Variable Costs
A fixed cost refers to unavoidable operational expenses that do not change largely in the short term (Drury, 2013). Fixed costs do not change even while the enterprise experiences variations in its productivity levels. Fixed costs include rent, insurance, salaries, property taxes, and equipment leases. Paff (2017) informs that there are two types of fixed costs, committed fixed costs and discretionary fixed costs. Committed fixed costs cannot be removed if the enterprise wishes to continue with its normal operations. An example is a factory lease for production equipment. On the other hand, discretionary fixed costs can be incurred during some period or delayed in other seasons. However, the discretionary cost can never be removed permanently. Examples of discretionary fixed costs are advertising budgets and worker development and training programs.
The fixed cost will be set aside in the expense section of a company’s income statement. Therefore, fixed costs directly influence the operating profit (Drury, 2013). For instance, depreciation is a fixed cost that is considered an indirect expense. Businesses will include a depreciation expense schedule for invested assets, explaining why they invest in periodic asset evaluations. Other fixed costs are listed and accounted for in a company’s cash flow statement and balance sheet (Drury, 2013). Short-term and long-term liabilities are examples of fixed costs listed in balance sheets. Any monetary transactions meeting the expenses of fixed costs are listed in the cash flow statement. Businesses will seek any opportunity to reduce fixed costs to positively impact the enterprise’s bottom line. A reduction in routine expenses means a higher profit margin.
A variable cost refers to expenses that vary (fluctuate) in congruence with the level of business productivity. Costs classified under this class will rise as production increases and collapse as production reduces (Drury, 2013). Examples of variable costs include the price of raw materials, packaging, utilities, shipping, labour, and transaction fees, among many others. Important to note is that the variable cost of production refers to the constant amount per unit produced. The total variable cost is the output quantity multiplied by the variable cost of production per unit.
Total variable cost= total quantity of output*variable cost per unit of output
The variable cost per unit of output will determine profits. For instance, it is normal practice for the variable cost for production per unit to reduce if the type of variable cost is sourced in batches (Drury, 2013). For instance, suppliers will lower the price of raw materials if a business purchases in bulk.
Application of Variable and Fixed Costs
Fixed costs are applied in the calculation of particular key financial metrics. One of the main applications is the formulation of the breakeven analysis. The metric determines the sales volume an enterprise needs to realize to start making a profit (Cafferky & Wentworth, 2014). A breakeven analysis is a critical component of the cost structure analysis. The graphical representation for the unit of sales required for a business to breakeven is referred to as the Cost Volume Profit (CVP) graph (refer to fig 1). The red line represents the summative fixed costs, the blue line covers the revenue per unit, and the yellow line covers the sum of fixed and variable costs.
Fig 1: sample CVP graph
According to the above image, the enterprise will start earning a profit when the amount of sold units surpasses 10000. The blue line will be greater than the yellow line. A breakeven analysis can help inform accountants whether a business should continue committing capital in production or reduce investments until the returns become tangible.
Fixed costs are used in the determination of operating leverage. Foremost, accountants can use the results of the breakeven analysis to perform a sensitivity analysis (Cafferky & Wentworth, 2014). The metric will inform management how sensitive the business is to further investing. Therefore, management becomes aware of the operating leverage. Accountants can use this metric to understand the proportion of fixed to variable costs. Higher fixed costs are associated with higher operational leverage (Cafferky & Wentworth, 2014). The implication is that companies produce more units and generate more profit with a higher operating leverage. Aforementioned is that accountants employ fixed costs to determine a business’ cost structure analysis. Complemented by operating leverage, a breakeven analysis will help management calculate its fixed charge coverage ratio. The metric informs on the firm’s solvency or the ability to meet fixed-charge obligations.
Data on variable costs are used in numerous ways, including pricing and profit analysis. A company can use its variable cost analysis to determine and set competitive prices (Panggabean & Wibowo, 2018). The analysis puts management in a better position to understand inputs and processed to be carried out to improve revenue per unit. For example, moving from grid power to in-house solar power is an example of a decision to increase the revenue per unit produced by reducing average operating cost. Variable costs are also an integral component of financial budgeting and planning. Businesses will continuously opt to improve on output to scale up revenue (Panggabean & Wibowo, 2018). The execution of such a strategy comes with the knowledge that variable costs will also increase. Any plans associated with growth and expansion or contract will result in proportional changes in variable costs.
Variable costs are used to determine and project net income and revenue margins. A combination of variable and fixed costs is used to calculate gross and profit margins (Panggabean & Wibowo, 2018). Through the execution of a simple variable cost analysis, accountants can identify ways scaling up or reducing production will influence profits. The variable cost analysis will directly influence a company’s expense structure. For external investors, the analysis helps determine profitability and the future earning potential of the enterprise. Variable costs, just like fixed costs, will also influence the operating leverage. While variable costs do not have a bigger effect than fixed costs, their impact is significant, especially in large, multinational corporations.
Fixed and variable costs are financial measures widely applied in accounting. Fixed costs remain intact over time while variable costs change with each incremental addition in produced unit. Accountants will employ the two measures to determine a business’ cost structure, protecting the firm from the possibility of business slowdown or increase in demand for goods. Companies can execute more effective investment decisions by assessing changes and the balance ration of variable and fixed costs. In addition, management can also execute various costing methods, including process costing and job-order costing. The result is each unit of production creates greater revenue margins. Fixed and variable costs form the basics of cost behaviour in contemporary business.
Cafferky, M. & Wentworth, J. (2014). Breakeven analysis: The definitive guide to cost-volume profit analysis [2nd Ed]. Business Expert Press.
Drury, C. M. (2013). Management and cost accounting. Springer.
Paff, L. (2017). Financial and managerial accounting. Penn State University, https://psu.pb.unizin.org/acctg211/
Panggabean, G. M. & Wibowo, D. (2018). Cost structure evaluation of variable costs and business forecast in spooring services at SME ban 83. Advances in Economics, Business, and Management Research, 72(12), 264-270.
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