2.4 Variable costs versus Fixed Costs
Slide 1
Costs have different behavioral patterns under various levels of activity. Some costs rise and fall under different activities and others remain the same. Understanding how costs behave is useful in the planning and controlling of an organization’s operations. In this section we will discuss “true” or “theoretical” variable and fixed costs behaviors. We will look at variable and fixed costs in total and per unit. In future sections we will look at deviations from these true behaviors.
Slide 2
First we have Total Variable Costs. The definition of total variable costs is that costs rise and fall in direct proportion to the activity. Notice the graph to the right. The X-axis is the units of activity and the y-axis is in units of money. As units are produced the cost to produce said units proportionally increases. Or, think of it like this; look at your long distance phone bill with your land line phone. So, for every minute you talk long distance your long distance bill increases proportionally.
Slide 3
Next we have Total Fixed Costs. The definition of total fixed costs is that costs remain the same or stay constant in total no matter the level of activity. Once again let us use the example of your land line phone to explain. To have the land line phone you pay a local provider a fixed fee. This fixed fee allows you to make local calls at will with no change in charge based upon number of local calls made. If you make only ten minutes of local phone calls for the month the fee remains the same as if you made 100 minutes of local phone calls.
Slide 4
Now are discussion takes us from total cost to per unit cost. Per unit variable costs remain the same no matter the activity level. The variable cost per unit remains constant whether you make ten units or a thousand units. Each unit costs the same. Going back to our phone example, long distance cost per minute on your land line remains the same per minute whether you make 20 minutes worth of calls or 100 minutes worth of calls.
Slide 5
Per unit fixed costs however behave much differently. As the level of activity increases the fixed cost per unit decreases. Going back to the land line phone example, the cost per unit of your fixed costs decreases as you rack up local phone call minutes over the month. For instance, if you have a $30 fee to maintain your land line and this gives you unlimited local calls, after ten minutes of local calls you per minute charge per local call is $3.00 per local minute. After 100 minutes the local calls now cost $0.30 per local minute. After 1000 minutes the local calls now cost $0.03 per local minute. As I said before, as you rack up the local calls the cost per local minute declines.
Slide 6
Here is a chance to apply what we just learned in a problem. Give it a try before going to slide 7 and the solutions.
Slide 7
Felt used in hat manufacturing would be variable. The cost of felt would proportionately increase as each hat was manufactured. Electricity used to run the ovens at Wonder Bread. The ovens will only be on when bread is baking so as bread is baked the electricity would go up proportionately. Three month advertising campaign. Advertising is one of those costs that can be classified as either fixed or variable. Let us say that for every product sold the customer gets a coupon for fifty percent off the next purchase. This is a form of advertising which increases the cost as each product is purchased. But, if you purchased a billboard on the highway the cost of that advertising would be fixed. Property insurance on the CEO’s office is fixed. The Baker’s salary at Wonder Bread would likely be considered variable. One would expect that the baker would make bread during his/her entire shift. However, a case can be made that the salary could be fixed if the baker supervised the baking of bread. This is the thing about cost classification there is a tremendous amount of variability. The important thing is to remain consistent in your classifications so that the reports mean something when they are prepared. Next we have fiberglass used in the manufacturing of a sports car. This would be variable as cost of fiberglass would increase as each sports car is manufactured. CEO’s salary is fixed.