The classification of costs into fixed and variable costs is useful for short-term decision-making. The classification is based on the pattern in which a cost changes with change in the volume of activity. The volume of activity is measured in terms of the unit of production or sales, hours worked, distance (e.g. kilometres) travelled, patients examined, students enrolled, or any other appropriate measure of the activity of an organization.
Difference # Fixed Costs:
Fixed costs, in total, are not affected by change in the activity level. They represent resources that cannot be adjusted quickly to the change in the activity level. An example of fixed cost is depreciation of property, plant, and equipment. The amount of depreciation remains same irrespective of the capacity utilization of the plant.
Depreciation does not change with the volume of production because the capacity of property, plant, and equipment cannot be adjusted quickly to the change in the volume of production.
Firms organize certain resources much in advance of actual operation. They organize such resources at two stages. At the first stage they create manufacturing and other facilities, which cannot be organized or modified in the short term. An example is the manufacturing facility (e.g. land, building, plant and equipment, and minimum support staff) created by a firm engaged in the conversion of raw materials and components into finished product (e.g. mobile phone, personal products, capital goods, and power).
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Similarly, facilities created by service industries (e.g. health care industry, hospitality industry, entertainment industry, and software industry) cannot be created or modified in the short term. The period which is perceived as short term varies between industries. E.g., short term for the software industry is much shorter than the short term for the automobile industry because the manufacturing facilities in a software firm can be organized or modified faster than those in the automobile industry.
Costs for the maintenance of the capacity, including salaries and wages of the minimum support staff and depreciation of facilities, are fixed costs.
Examples of fixed costs related to capacity created by firm are rent, rates, insurance premium for the factory and office building, depreciation of property, plant, and equipment, salaries of the top management (CEO, COO, CFO), salaries and wages of maintenance staff, and the cost of maintaining the minimum administrative structure.
Firms organize or commit for some resources based on the planned activity level before the commencement of the plan period. E.g., firms organize or commit resources to train skilled workforce based on the skills required to implement medium-term strategy incorporated in the corporate plan before the commencement of the corporate plan.
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Firms organize or commit some resources based on the planned activity level before the commencement of the budget period. E.g., a company that fabricates transmission towers and which retains freelance designers to design towers retains required number of design engineers before the commencement of the budget period. The retention fee payable to design engineers is a fixed cost.
In the long run, every cost is a variable cost. Therefore, it is said that the fixed costs are fixed for the relevant range and for the relevant period.
Relevant range is the range within which the fixed cost does not change. If the activity is increased beyond the range, the fixed cost will change.
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The relevant range for fixed costs related to capacity created by the firm is from zero to the attainable capacity. E.g., if the capacity of a manufacturing facility is to produce 100,000 units, the relevant range for facility related costs is 0-100,000 units. The relevant range for fixed costs that represent resources organized to achieve the planned level of activities is from zero to the planned activity level.
Fixed cost is the monetary measure of the amount of resources organized. The money value of resources is calculated by multiplying the quantity by the price per unit. Therefore, even if the quantity of a resource remains the same, the fixed cost related to that resource changes if the price changes.
E.g., even if the number of supervisors in place remains the same, supervisors’ salary changes if the salary per supervisor changes. Relevant period is the period over which prices are not expected to change. Usually, one year is considered to be the relevant period.
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Fixed cost, in total, does not change with change in activity level. Therefore, average fixed cost increases with the decrease in volume of activity and decreases with the increase in volume of activity.
We have plotted the data given in Table 1.1 in Exhibits 1.1 and 1.2:
Difference # Variable Cost:
The total amount of a variable cost changes in direct proportion to the activity level. Variable costs represent resources that can be adjusted instantaneously to the change in the activity level. An example of the variable cost is direct material.
Theoretically firms can procure raw material in the lot of materials required for the production of one unit. In fact, in industries where the product is not a standard product (e.g. power transformer), material is procured on receipt of the order or in anticipation of the receipt of the order.
In case of standard products (e.g. audio systems), firms maintain a stock of raw materials to ensure smooth flow of material to the production process, but theoretically they can purchase the required quantity of raw material whenever they decide to produce an additional unit of the finished product.
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Similarly, when direct workers are paid at piece rate, notionally, the firm purchases the service (resource) when one unit of the product is produced. Therefore, the cost of services from workers, who are paid at piece rate, is a variable cost.
Cost of services of workers, who are paid monthly wages, is a fixed cost, provided the company as a policy or due to statutory requirements, do not lay off workers when the activity is reduced. If the company can adjust the number of employees quickly to the change in volume of activity, for all practical purposes, labour cost is considered a variable cost, even if workers are paid monthly wages and are on the role of the firm.
All direct costs are variable cost. Total variable cost changes in direct proportion to the change in volume of activity because variable cost per unit remains constant. We assume that the linear relationship between variable costs and volume of production remains valid at any production level.
But that may not be true in practice. E.g., quantity discount may be available on purchase of raw material after the threshold level of production is achieved, thereby reducing the cost of raw material per unit of production. Similarly, learning curve effect may reduce the direct labour cost per unit of production at successively higher volume of production.
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The data is given in Table 1.2 in Exhibits 1.3 and 1.4:
Semi-Variable Cost:
A semi-variable cost is the one whose total amount varies with the change in activity level, but not in direct proportion. Cost accounting techniques presume that all cost items can be grouped under either ‘fixed cost’ or ‘variable cost’. Methods, including statistical methods (e.g. scatter graph method and least square method), are used to break down semi-variable costs into fixed and variable components.
The simplest method is to compare the total cost and volume of two periods and divide the change in total cost by the change in volume to determine the variable cost component.
Illustration 1. Segregation of Fixed and Variable Elements:
This method gives a very rough approximation of the fixed cost and variable cost per unit. Statistical methods provide much more accurate results.
An example of semi-variable cost is the cost of electric power, which has an element of fixed cost (e.g. amount payable on the basis of connected load) and an element of variable cost (e.g. amount payable on the basis of units consumed). The fixed cost portion remains constant at all activity levels.
The variable cost component may apply to all activity levels or may come into operation after the activity level touches a particular point. E.g., if salesmen are entitled for a fixed salary plus a commission for every rupee sales, salesmen’s compensation is a semi-variable cost in which the fixed cost component (i.e. fixed salary) is constant for all activity levels and the variable cost component (i.e. commission) operates at all activity levels and varies in proportion to the change in activity level.
If salesmen are entitled for a fixed salary plus a commission for sales in excess of a pre-determined sales level, salesmen’s compensation is a semi-variable cost composed of a fixed cost component constant at all activity levels and a variable cost component which comes into operation once the specified level of sales is achieved.
Identification of Fixed Cost Items and Variable Cost Items:
There are two simple tests to classify costs into fixed cost and variable cost. The first is to examine the direction in the change in total cost. If the change is in the same direction as change in the volume of activity, it is likely that the cost is a variable cost. The second test is to calculate cost per unit at different activity levels.
If cost per unit remains almost constant, it is a variable cost. If the cost per unit changes, it is a fixed cost. The result of these methods of classification lacks precision, because they fail to identify semi-variable costs separately from fixed costs and variable costs. However, these methods are simple and practical.
Statistical methods should be applied for classification of costs into fixed costs and variable costs precisely.
Illustration 2. Identification of Fixed Costs and Variable Costs:
Details of costs for previous five years are given in the tabular form below:
An examination of the total amount of each item of cost shows the following:
(a) The change in the material cost is in the direction of the change in the volume. Therefore, it is a variable cost.
(b) The change in the direct labour cost is not in the direction of change in the volume. It increased when the volume reduced from 1,000 to 800 units. Similarly, when the volume reduced from 1,200 to 1,100 units, the cost increased. The increase in cost from year to year appears to be due to inflation or normal increment in wages allowed to workers. Therefore, the labour cost is a fixed cost.
(c) The change in the cost of consumables is not in the direction of change in the volume. Therefore, the cost of consumables is a fixed cost.
(d) The change in the cost of power and fuel is in the direction of the change in the volume. Therefore, it is a variable cost.
(e) There is no change in water charges. Therefore, the cost of water is a fixed cost.
(f) There is no change in the amount of rent and rates from year to year. Therefore, the ‘rent and rates’ is a fixed cost.
(g) The cost of repair and maintenance did not change when the volume reduced from 1,000 to 800 units. The cost increased when the volume reduced from 1,200 to 1,100 units. Therefore, the cost of repairs and maintenance is predominantly a fixed cost.
An analysis of cost per unit reflects the following:
a. Material cost per unit is almost constant at different level of activities. The difference appears to be due to change in prices. Therefore, the material cost is a variable cost.
b. Direct labour cost per unit is not constant. Therefore, it is a fixed cost.
c. Consumable cost per unit is not constant. Therefore, it is a fixed cost. Total cost is reducing, presumably because of management’s cost management initiatives.
d. Power cost per unit is almost constant. Therefore, it is a variable cost.
e. Water charge per unit is not constant. Therefore, it is a fixed cost.
f. ‘Rent and rates’ cost per unit is not constant. Therefore, it is a fixed cost.
g. ‘Repairs and maintenance’ cost per unit is not constant. Therefore, it may be treated as fixed cost.
Both the tests give same results. Material cost and power cost are variable costs. Other costs are fixed costs.
Costs, other than variable costs, change in steps. These costs remain constant over ranges of output, but as activity level moves from one range to the next, they change by discrete amounts. This behaviour occurs for inputs which are acquired in discrete quantities but are used in fractional quantities. Supervisor’s salary is an example of step cost.
Increase in the number of workers in a group beyond the optimum number requires one more supervisor for effective supervision. If a supervisor can effectively supervise 10 workers, increase in the number to 11 needs the service of a second supervisor and if the number increases beyond 20 but remains within 30, a third supervisor will be required. Thus, a supervisor’s salary increases abruptly as the activity level changes from one range to another.
Generally, labour costs of all sorts present this pattern of behaviour because:
(a) Labour is acquired in indivisible chunks; and
(b) Labour services cannot be stored; they are either used or lost as the workday ends.
The width and height of steps vary depending on the nature of the cost. If the steps are narrow and small, the behaviour pattern approximates pure variable cost pattern and, therefore, is termed as ‘step-variable costs’.
If the steps are wider, the step cost is termed as ‘step fixed cost’, because in such cases the behaviour of costs approximates fixed cost pattern.
In many situations, steps can be managed by managerial actions.