Friday, 20 January 2012

Variable vs Fixed Cost

Variable vs Fixed Cost

Define Fixed and Variable Costs:

In accounting, a distinction is often made between variable costs and fixed costs. Variable costs change with activity or production volume. Fixed costs remain constant regardless of activity or production volume.
 In accounting, all costs can be described as either fixed costs or variable costs. Variable costs are inventoriable costs – they are allocated to units of production and recorded in inventory accounts, such as cost of goods sold. Fixed costs, on the other hand, are all costs that are not inventoriable costs. All costs that do not fluctuate directly with production volume are fixed costs. Fixed costs include indirect costs and manufacturing overhead costs.
When comparing fixed costs to variable costs, or when trying to determine whether a cost is fixed or variable, simply ask whether or not the particular cost would change if the company stopped its production or primary business activities. If the company would continue to incur the cost, it is a fixed cost. If the company would no longer incur the cost, then it is most likely a variable cost.

Variable Cost, Fixed Cost – Examples:
For example, if a telephone company charges a per-minute rate, then that would be a variable cost. A twenty minute phone call would cost more than a ten minute phone call. A good example of a fixed cost is rent. If a company rents a warehouse, it must pay rent for the warehouse whether it is full of inventory or completely vacant.


Other examples of fixed costs include executives’ salaries, interest expenses, depreciation, and insurance expenses. Examples of variable costs include direct labor and direct materials costs.


Fixed and Variable Costs and Decision-Making:
When making production-related decisions, should managers consider fixed costs or only variable costs? Generally speaking, variable costs are more relevant to production decisions than fixed costs.


For example, if a manager is deciding between keeping production levels constant or increasing production, the primary factors in this decision will be the variable or incremental costs of the production of additional units of output, and not the fixed costs related to the operations that cannot be altered and will not change with the level of production. Therefore, in most straightforward instances, fixed costs are not relevant for production decision, and incremental costs, or variable costs, are relevant for these decisions.

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Semi Variable Costs:
Semi-variable costs are costs that include both a fixed and a variable component. Semi-variable costs are also called mixed costs.

Semi-Variable Cost Example 1:
Here is an example of a semi-variable cost. Let’s say you subscribe to a phone service that charges $40 dollars per month, plus $0.10 per minute for each additional minute beyond 500 minutes per month.

If you talk for less than 500 minutes per month, the cost is $40 dollars per month. Beyond 500 minutes, the cost increases. This is an example of a semi-variable cost. The flat rate of $40 dollars for 500 minutes is the fixed cost component. The additional $0.10 per minute for each additional minute beyond 500 minutes is the variable cost component.

Semi-Variable Cost Example 2:
Here is an example of a slightly different type of semi-variable cost. Let’s say a manufacturing company has an electric bill that uses semi-variable cost, including a fixed cost component and a variable cost component.

The electric company charges the manufacturing company a flat monthly rate of $300 dollars per month for basic electricity service, and then charges $0.015 per kilowatt hour (kwh). In this example, the flat rate of $300 dollars per month is the fixed cost component and the $0.015 per kwh is the variable cost component.

If the manufacturing company uses 50,000 kwhs of electricity in a particular month, its electric bill would be $1,050 dollars. ($1,050 = $300 + ($0.015 x 50,000kwhs)). And if the manufacturing company uses 100,000 kwhs of electricity the following month, its electric bill would be $1,800 dollars. ($1,800 = $300 + ($0.015 x 100,000kwhs)).

Accounting Treatment:
Cost accountants typically separate semi-variable costs into their two distinct components – the fixed cost component and the variable cost component – when dealing with semi-variable costs. The fixed cost component is treated separately as a fixed cost; the variable cost component is treated separately as a variable cost. This may cause a differentiation of cost that does not reflect economic reality, but it makes it easier to handle and examine the effects of semi-variable costs.

Source:

Barfield, Jesse T., Michael R. Kinney, Cecily A. Raiborn. “Cost Accounting Traditions and Innovations,” West Publishing Company, St. Paul, MN, 1994.

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