COMM 1102- Fixed and Variable Cost

Cost Behavior in Decision Making

  • Understanding cost behavior is crucial for predicting future decisions.

  • There are three main types of costs discussed: variable costs, fixed costs, and mixed costs.

Cost Types

Variable Costs

  • Definition: Costs that fluctuate directly with the level of production or volume of activity.

  • Behavior: Variable costs increase in total as production volume increases.

  • Key Points:

    • Total Variable Costs increase directly in proportion to changes in volume.

    • Variable Costs per Unit remain constant regardless of production levels.

Fixed Costs

  • Definition: Costs that do not change with the level of production or volume of activity.

  • Behavior: Fixed costs remain constant regardless of how many units are produced.

  • Example: Lease costs for a hotel or depreciation that do not vary with the number of guests.

Mixed Costs

  • Definition: Costs that have both fixed and variable components.

  • Example: Utility costs for a hotel.

    • Base charge (fixed cost) of $2,000 remains constant, but increases with usage due to more guests (variable cost).

  • Total mixed cost includes both constant and volume-related components.

Relevant Range

  • Definition: The range of activity within which the fixed cost remains constant.

  • Example: If a hotel leases an additional location, fixed costs will increase only within this relevant range.

Characteristics of Variable Costs

  • Total variable costs fluctuate based on production volume.

  • Important distinctions:

    • Total Variable Costs increase incrementally with each unit produced (e.g., if the variable cost is $3 per unit, producing 3 units results in a total of $9).

    • Variable costs per unit do not change with volume (remains $3 in the example).

Cost Estimation and Calculations

Total Cost Calculation

  • Formula: Total Cost (Y) = Fixed Cost (FC) + (Variable Cost per Unit (VC) x Number of Units Produced (Q))

  • If producing 0 desks, the total cost equals the fixed cost alone due to no variable costs being incurred.

  • Example Calculation:

    • Fixed Cost = $10,000

    • Variable Cost for materials = $30 per desk

    • Variable Cost for labor = $20 per desk

    • Total Variable Cost per desk = $30 + $20 = $50

  • Thus, total cost can be depicted as follows:

Y = 10,000 + 50Q

Discounts and Variable Cost Behavior

  • Volume discounts can affect variable costs:

    • Example: A variable cost might start at $3 per unit but decrease to $2.75 per unit after reaching a certain production level due to discounts.

  • Step costs may appear where additional fixed costs are incurred at specific volume thresholds (like needing to hire more staff after certain figures).

Total Operating Costs

  • Calculation methods for operating costs:

    • Total Variable Costs + Total Fixed Costs = Total Operating Costs.

  • Example:

    • Total Variable Costs = $105,107.50

    • Total Fixed Costs = $10,000.

    • Resulting Total Operating Cost = $115,107.50.

Fixed Cost Allocation

  • Fixed Cost per Member Calculation:

    • Formula: Fixed Cost per Member = Total Fixed Costs / Total Members

    • Example: Total Fixed Costs of $10,000 over 100 members results in $100 fixed cost per member.

Absorption vs. Contribution Margin Costing

  • Traditional Income Statement: Required by external reporting standards.

    • Understand that it is designed for stakeholders outside of the company.

  • Contribution Margin: A tool for internal management and decision-making, used primarily by managers.

    • Helps in understanding profitability and controlling costs.

Definitions

  • Absorption Costing:

    • Method that assigns all manufacturing costs (both fixed and variable) to the cost of a product. This includes:

    • Direct Material

    • Direct Labor

    • Variable Manufacturing Overhead

    • Fixed Manufacturing Overhead

    • Products absorb fixed manufacturing overhead, making it part of their cost.

  • Variable Costing:

    • Assigns only variable manufacturing costs to products. Fixed manufacturing overhead is treated as a period cost. The key components are:

    • Direct Material

    • Direct Labor

    • Variable Manufacturing Overhead

    • Important for internal reporting and allows for better control over operations and pricing.

Contribution Margin Income Statement

  • Distinguishes between fixed and variable costs based on their behavior, aiding in internal decision-making.

  • Format includes:

    • Revenue

    • Less Variable Costs

    • Equals Contribution Margin

    • Less Fixed Costs

    • Equals Operating Income

Segment Reporting

  • Useful for companies with multiple divisions to evaluate profitability.

  • Common fixed costs should not be allocated to segments as they do not provide insight into segment performance.

Key Concepts

  • Segment Margin: Revenue minus variable costs for each segment; it assesses the profitability of each segment without interference from common costs.

  • Traceable Fixed Costs: Costs that can be directly attributed to a specific segment, necessary for detailed performance analysis.

  • Common Costs: Indirect costs that cannot be traced directly to a segment; these are typically excluded from segment performance analysis as they do not affect managerial decisions regarding the segments.

Applications and Implications

  • Understanding these concepts is crucial for managerial decision-making regarding product lines, pricing strategies, and cost control efforts.

  • Managers need to identify traceable fixed costs accurately to assess the profitability of each segment effectively.

  • Impact on strategic decisions may include determining product lines' viability, resource allocation, and overall operational efficiency.

Summary Points

  • Understanding cost behavior is crucial for effective decision-making in business management.

  • Being able to distinguish between variable, fixed, and mixed costs allows for better financial forecasting and budgeting.