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Fixed Costs vs. Variable Costs

Fixed costs

Fixed cost are defined as those which do not vary with the level of output.5

Fixed costs are the costs that do not increase and decrease with the size of the production.

The fixed costs are the costs of having a given production capacity. In the car case, these are examples of fixed costs

o insurance

o vehicle excise duty

o value loss of car because of age

Insurance and vehicle excise duty are fixed costs because they do not vary with the mileage.

Variable costs

Variable costs changes as the level of output changes.6

Variable costs are the costs that increase and decrease with the production. In the car case these are examples of variable costs:

o Fuel

o Maintenance

o Value lost on the car because of mileage

Fuel and maintenance are variable costs as they vary with the mileage

But there are also some problems. If the product is "one driven kilometer," then its obvious that the use of fuel is not the same if you drive economically or fast, in the city or on a highway, or are stuck in traffic during rush-hour. With a midsize class car it may mean a difference between a car driving 15 km/liter or driving 4 km/liter. The wear and tear on brakes, clutch etc. is also very different.

If a cab driver in northern Jutland is to sell his cab, based on the above stated reasoning, then he will promote it as a country-cab; i.e. a "northern-Jutland-Mercedes-cab" despite it having driven the same amount of miles as a "Copenhagen-city-Mercedes-cab," it has experienced significantly less wear and tear. Once again, it is not that simple to present an unambiguous coherence between product and costs.

The problematic classic treatment of variable costs

The problem of the classic cost-theory is that variable costs are treated exclusively, as variables compared to the determined unit, e.g. size of production, mileage, etc.

Other factors can equally influence the variable costs:

o Motivation for work among the employees, i.e. efficiency.

o Employee treatment of materials, machinery, equipment etc. i.e. use of resources.

o Organization of the work, i.e. the management solution.

o The more complex the production is the greater the role played by education, communication, understanding of the firm's culture etc. which is why these factors have to be optimized as well.

Only by focusing on all the influencing factors is the achievement of the lowest possible cost assured.

Costs of owning and driving a car

In the following section, fixed and variable costs are explained on the basis of the costs of owning and driving a car. The annual costs of owning and driving a car are, for the sake of simplicity, illustrated in figure 1.3, where the mileage (Q = quantity) is depicted along the horizontal x-axis and the costs measured in DKK are shown along the vertical y-axis.

The costs are communicated as variable, fixed, and total cost functions. As seen in figure 1.3 the variable costs increase with mileage, while the fixed costs remain at the same level, independently of the mileage. Furthermore, it is clear that the total costs are the sum of the fixed and variable costs.

Some Implicit assumptions are made:

o Time horizon is a one year.

o Getting rid of the car during this year is not an option.

o Driving needs are stable, and the manner of driving remains unchanged (the mix of city and countryside, aggressive and careful driving) etc.

o Accidental costs are said to be estimable and calculable; e.g. repairs, tires etc.

Figure 1.3: Annual costs of owning and driving a car as a function of the number of kilometers driven

Annual costs of owning and driving a car as a function of the number of kilometers driven

Determining unit of activity

Based on the car case, there are no obvious difficulties connected to defining the car's activity level as the kilometers driven. This unit seems to be both a natural and operational calculation unit. Concerning truck driving, bus driving and other machine-based services, "hours" are frequently the unit of measure, no matter if the machine works more or less. In each situation both measures can be more or less right or wrong. The costs vary in proportion to both variables, hours or kilometers, depending on the activity. But this variation is not identical in different situations.

For production firms, the number of units produced, denoted as Q for quantity, is most often the unit of determination. But for other industries such as restaurants, architectural firms, and law firms, there are no comparable measurement units. In these cases the number of hours, turnover, or even amount of costs, can be the product; as assignments differ greatly, this may be the only common denominator.

This variability means that the decision maker has exert themselves to find suitable measurement units See examples below:

o Concerning restaurants, the number of customers or the turnover typically will work as a measurement unit for the level of activity. The problem with the number of guests being used as the measurement unit is that there is a great difference in activity level, from guests who only order one course and a glass of wine, to those that order the full 5-course dinner with the accompanying wine menu. Turnover is also problematic, as the measurement of the activity level is affected by the price level, the earnings on the different products (drinks versus food), as well as price promotions. So, turnover is not without problems when applied as measurement unit

o In regards to architectural firms and law firms, the number of working hours is a natural unit of measurement for level of activity. However, when applied as measurement unit, the number of working hours involves a great deal of uncertainty. Both concerning time and finances, there is a great difference between hours worked by a newly educated (working slowly at a low wage) individual as compared to a more experienced (working fast at a high wage) architect/lawyer. Furthermore, more hours are not necessarily equal to a better job done. The total work load may also affect both work speed and work effort. Both professions tend to let the number of hours decide the magnitude of a given assignment.

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