Defining Fixed and Variable Costs
All business entities’ main goal is to make a profit by offering products or services. Cost plays an integral role when we make a business decision that is geared towards attaining our goal. Costs are generally categorized into two groups, fixed and variable costs. We will define between fixed and variable costs and how each behaved differently with the change in the level of output. Defining Fixed and Variable Costs What is Cost? Before we can differentiate between fixed and variable cost, let us first define what is cost. Baker (2000) said total cost is what it costs to operate at some particular rate of output.
Investor words (“Online Financial Glossary,” n. d. ) defines cost as the total money time and resources associated with a purchase or activity. According to the US Chamber of Commerce (“Finance Toolkit”) before you can use cost/volume/profit analysis in evaluating your business you need to get a handle on your fixed costs as compared with your variable costs. What are Variable and Fixed Costs? According to Sollenberger and Schneider (1996), variable cost changes in total indirect proportion to changes in activity or output. A decrease in activity brings a proportional decrease in total variable cost and vice versa.
Fixed cost on the other hand is constant in total amount regardless of changes in activity level. Fixed cost per unit decreases as activity or volume increases and vice versa. (Sollenberger & Schneider, 1996) Scenario. Suppose we are running a restaurant and have identified certain costs along with the number of annual units sold of 1000, annual raw materials costs of 650, and annual rent of 9000. Let us then identify what are our fixed and variable costs and the cost per unit of each. Raw Materials Building Rent Units Unit cost Total cost Unit cost Total cost 1000 0. 65 650. 00 9. 00 9,000. 00
With 1000 units, the unit cost of raw materials would be . 65 while the building rent is 9 for each unit produced. At this point, both may still be considered fixed cost for the simple reason that there is still no change in the productivity or output. Suppose we increase output to 6000 units then to 8000 units the following year and still within the relevant range. What would now be our total annual cost and unit costs? Would our costs still be fixed or variable? Raw Materials Building Rent Units Unit cost Total cost Unit cost Total cost 1000 0. 65 650. 00 9. 00 9,000. 00 6000 0. 65 3,900.
00 1. 50 9,000. 00 8000 0. 65 5,200. 00 1. 13 9,000. 00 On a per unit computation, it looks as if raw materials is fixed while rent is variable but we do our cost analysis based on the total costs and not on a per unit cost and as defined above, we know that variable costs changes in direct proportion to productivity or output while fixed costs remains the same regardless of the output. Thus, the total annual cost of raw materials is our variable costs because as we increase the output, so did our total costs while building rent remains the same regardless of the change in our output. References
Baker, S. L. (1985-2000). Cost Concepts. Economics Interactive Tutorials. Retrieved January 5, 2008 from http://hadm. sph. sc. edu/COURSES/ECON/Cost/Cost. html Investorwords. Online Financial Glossary. Retrieved January 05, 2008 from http://www. investorwords. com/5221/variable_cost. html Sollenberger, H. M. & Schneider, A. (1996 Philippine Copyright). Managerial Accounting. Cincinnati, Ohio: Southwestern College Publishing. US Chamber of Commerce. Finance Toolkits. Retrieved January 05, 2008 from the US Chamber of Commerce for Small Business Center online database http://www. uschamber. com/sb/business/P06/P06_7510. asp