Tag Archives | controlling costs

Variable vs Fixed Costs

See Also:
Absorption vs Variable Costing
Semi Variable Costs
Sunk Costs
Marginal Costs
Average Cost

Variable vs Fixed Cost

Define Fixed and Variable Costs

In accounting, a distinction is often made between variable costs and fixed costs. Variable costs change with activity or production volume. Fixed costs remain constant regardless of activity or production volume.

In accounting, all costs can be described as either fixed costs or variable costs. Variable costs are inventoriable costs – they are allocated to units of production and recorded in inventory accounts, such as cost of goods sold. Fixed costs, on the other hand, are all costs that are not inventoriable costs. All costs that do not fluctuate directly with production volume are fixed costs. Fixed costs include indirect costs and manufacturing overhead costs.

When comparing fixed costs to variable costs, or when trying to determine whether a cost is fixed or variable, simply ask whether or not the particular cost would change if the company stopped its production or primary business activities. If the company would continue to incur the cost, it is a fixed cost. If the company would no longer incur the cost, then it is most likely a variable cost.

Variable Cost, Fixed Cost – Examples

For example, if a telephone company charges a per-minute rate, then that would be a variable cost. A twenty minute phone call would cost more than a ten minute phone call. A good example of a fixed cost is rent. If a company rents a warehouse, it must pay rent for the warehouse whether it is full of inventory or completely vacant.

Other examples of fixed costs include executives’ salaries, interest expenses, depreciation, and insurance expenses. Examples of variable costs include direct labor and direct materials costs.

Fixed and Variable Costs and Decision-Making

When making production-related decisions, should managers consider fixed costs or only variable costs? Generally speaking, variable costs are more relevant to production decisions than fixed costs.

For example, if a manager is deciding between keeping production levels constant or increasing production, the primary factors in this decision will be the variable or incremental costs of the production of additional units of output, and not the fixed costs related to the operations that cannot be altered and will not change with the level of production. Therefore, in most straightforward instances, fixed costs are not relevant for production decision, and incremental costs, or variable costs, are relevant for these decisions.

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Agency Costs

See Also:
Are You Collecting the Data You Need to Run Your Business?
Average Cost
Sunk Costs
Restructuring Expense
Joint Costs
Commercial Agents

Agency Costs

Agency costs are internal costs incurred from asymmetric information or conflicts of interest between principals and agents in an organization.

In a corporation, the principals would be the shareholders and the agents would be the managers. The shareholders want the managers to run the company in a way that maximizes shareholder value. The managers, on the other hand, may want to run the company in a way that maximizes the managers’ own personal power or wealth, even if it lowers the market value of the company. These divergent interests can result in agency costs. There are three common types of agency costs: monitoring, bonding, and residual loss.

(NOTE: Want the Pricing for Profit Inspection Guide? It walks you through a step-by-step guide to maximizing your profits on each side. Get it here!)

Monitoring costs are incurred when the principals attempt to monitor or restrict the actions of agents. For example, the board of directors at a company acts on behalf of shareholders to monitor and restrict the activities of management to ensure behavior that maximizes shareholder value. The cost of having a board of directors is therefore, at least to some extent, considered an agency monitoring cost. Costs associated with issuing financial statements and employee stock options are also monitoring costs.

Bonding costs are incurred by the agent. An agent may commit to contractual obligations that limit or restrict the agent’s activity. For example, a manager may agree to stay with a company even if the company is acquired. The manager must forego other potential employment opportunities. That implicit cost would be considered an agency bonding cost.

Residual losses are the costs incurred from divergent principal and agent interests despite the use of monitoring and bonding.

Calculate agency costs when setting prices and start pricing for profit. Download the free Pricing for Profit Inspection Guide.

agency costs

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agency costs

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Absorption vs variable costing Advantages and Disadvantages

See Also:
Absorption vs Variable Costing

Absorption vs variable costing Advantages and Disadvantages

Variable Costing Disadvantages and Advantages

Variable costing may provide a clearer picture of the actual incremental costs associated with a specific product. Essentially, the variable costing method can give producers and those concerned with financial records an accurate representation of what actually goes into the costs of producing. Proponents of variable costing argue that fixed manufacturing overhead costs are incurred regardless of production volume and therefore should not be considered in product-related decision-making. Therefore, variable costing method users can enjoy a reported cost that is representative of the actual inputs to the products. However, by ignoring fixed manufacturing overhead costs, variable costing may understate a product’s overall cost. The manufacturing overhead is important because, though the costs included in overhead do not contribute directly to the creation of the product, there is still some residual effect on the production which drives up the cost to produce.

Absorption Costing Disadvantages and Advantages

In contrast to the variable costing method, absorption costing may provide a fuller picture of a product’s cost by including fixed manufacturing overhead costs. A proponent of this method would argue that it is most effective because, simply enough, all the possible costs are included. What this method does is give a company or organization a more accurate view of the products importance from an economic standpoint. If the product is turning over a good amount of revenue in the absorption costing method, that means that it is turning over revenue in addition to the unrelated costs of production. However, absorption costing ignores the differential usage of indirect resources across products or product lines. Also, absorption costing can be used as an accounting trick to increase net income by moving fixed manufacturing overhead costs from the income statement to the balance sheet simply by increasing production volume disproportionately to sales volume.

Absorption Costing GAAP

Absorption costing is required for external reporting by GAAP.

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Insulate Your Company from Rising Health Insurance Costs

“How many times have your employees — or even potential employees — expressed concerns about the cost of the health insurance that your small business provides. It’s an employee concern that most small business owners dread discussing because providing comprehensive health care can be a substantial cost burden. There are small business owners who can afford to provide a competitive benefits package in the short-term, but many are not aware that their rates can increase in the long-term as the result of employee illnesses that require substantial medical care and cost.

Going It Alone

Often times, small businesses implement a health insurance plan one year, only to see their costs skyrocket in subsequent years due to the health experience of their small employee base. If there have been health conditions that resulted in significant costs, insurance rates for the small group plan rise, and a once competitive plan becomes a cost burden to the company. When a small or medium-sized business obtains its own health care coverage and is faced with a significant rate increase due to the performance or cost burden generated by the small pool of employees, difficult choices emerge:

• Eliminate or reduce coverage

• Increase the employer contribution to the premium

• Increase employee premiums

Partnerships Can Help

To help protect themselves from these types of increases, many small businesses choose to partner with a Professional Employer Organization (PEO). PEOs operate under a co-employment model which is based on a commitment by the PEO to share employment-related risk with clients, thereby helping to reduce financial exposure…”

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How to Control Annual Audit Fees

Annual audits of a company’s financial statements may be required by partnership, loan or other agreements. The cost of an annual audit can constitute a significant administrative expense, if not properly managed by the company’s financial staff. Although the independent accountant has the responsibility of establishing the scope of the audit required in order for him to issue an opinion on the financial statements, the company can limit the involvement of the independent accountant’s staff, in order to keep the audit fee at appropriate levels.

The following procedures should be adopted in order to minimize annual fees and to assure appropriate cooperation between the company’s financial staff and the independent accountant…

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Implementing Activity Based Costing

All of us have used cost allocation, the process of assigning common costs to ending inventory and cost of goods sold (COGS), as part of our Financial Services offerings since it is required by GAAP. Our goal has been to either reduce taxes or increase reported earnings, depending on our client’s needs and circumstances.

But what about cost allocation’s other uses? Are we shortchanging our clients by not offering services in this area (usually referred to as cost or management accounting services)?

Managers’ use cost allocation for a number of reasons. First and foremost, cost allocation provides a methodology for assigning overhead costs of various activities, usually support departments, to products or services being produced and/or sold allowing upper management to assess and analyze their profitability. By knowing what the true “cause-and-effect” relationship is, managers are able to more accurately assess the true cost of a product or service and determine if carrying certain products and/or services contributes to overall profitability given the demand for and price these products/services sell for. This is especially important as it pertains to both operational decisions (such as calculating the maximum price a firm can charge, especially for a “commodity” product, determining the maximum cost a firm is willing to pay to provide this product or service, and in making special order and transfer pricing decisions) and capital/long-term decisions (such as make-or-buy component decisions, continue or discontinue a product line decisions, process further decisions, etc,).

Cost allocation can also be used to reduce wasteful spending and/or promote more efficient use of resources (especially PP&E) by evaluating needs and uses for the year to come as part of the planning/budgeting process. Managers can then be evaluated on their planning effectiveness, leading to better communication, sharing of resources, and cost efficiency. It can also used to manage product and process design. As allocations are broken down/determined, the use of resources becomes transparent from a process standpoint, allowing managers to improve operations as needed….

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