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Fixed Costs

See Also:
Variable vs Fixed Cost
Marginal Costs
Semi Variable Costs
Standard Costing System
How to Prepare a Break Even Analysis

Fixed Costs Definition

In accounting, fixed costs refer to costs that do not vary with production volume. They remain relatively constant regardless of the company’s level of production or business activity. Fixed costs are in contrast to variable costs, which increase or decrease with the company’s level of production or business activity. Together, fixed costs and variable costs comprise the total cost of production.

A fixed cost does not necessarily remain perfectly constant. It can vary. But they do not vary correspondingly with production or business activity. For example, certain factors may cause a company’s utility bills to go up. An uncommonly hot summer may require more air-conditioning and higher energy bills. This fluctuation in a fixed cost, however, has no relation to the level of the company’s business activity so it is still considered a fixed cost.

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. These costs include indirect costs and manufacturing overhead costs.


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Fixed Costs Examples

Good examples of fixed costs include rental payments and utility bills. If a widget-producing company operates out of a building, it must pay rent and utility bills for its space. During a month in which widget sales are very high, the company pays a set rate for rent and utility bills. During a month in which widget sales are slow, the company still pays the same rent and the same utility bills. Rent and utility bills do not fluctuate with the level of business activity.

Fixed Costs and Decision-Making

When making production-related decisions, should managers consider fixed 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 incremental or marginal 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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Contribution Margin Definition

See Also:
Margin vs Markup
Segment Margin
Marginal Costs
Segmenting Customers for Profit
Financial Ratios

Contribution Margin Definition

Contribution margin (CM), defined as selling price minus variable cost, is a measure of the ability of a company to cover variable costs with revenue. The amount leftover, the contribution, covers fixed costs or is profit.

Contribution Margin Meaning

Contribution margin means a measurement of the profitability of a product. In addition, express it as a dollar amount per unit or as a ratio. CM can be calculated for a product line using total revenues and total variable costs. It can also be calculated at the unit level by using unit sales price and unit variable cost. The metric is commonly used in cost-volume-profit analysis and break-even analysis.

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Contribution Margin Formula and Contribution Margin Ratio Formula

Use the following contribution margin formula below:

CM = Unit Price – Unit Variable Cost

The contribution margin ratio, or contribution margin percentage, is the CM expressed as a percentage of the unit sales price. Calculate it using the following formula:

CM Ratio = (Unit Price – Unit Variable Cost) / Unit Price

Contribution Margin Calculation

After you collect all the information, it is fairly easy to calculate CM. For example, a company has a $1,000 unit price and a $150 unit variable cost

Contribution margin per unit= $1,000 – $150 = $850

Contribution Margin Ratio Calculation

The contribution margin equation can also be applied to create a ratio for the given values. For example, a company has a $1,000 unit price and a $150 unit variable cost

CM = ($1,000 – $150) / $1,000 = .85

Contribution Margin: Income Statement

The CM format income statement is a variation on the standard income statement that separates variable costs and fixed costs. It starts with revenues, subtracts variable costs, and then displays the CM, as well as, the CM percentage before subtracting fixed costs and giving the net operating income. A simplified CM format income statement might look like the following:

Revenue        $100,000

Variable costs
Raw material$15,000
Variable labor$20,000
Delivery charge        $5,000
Total variable costs$40,000
Contribution margin$60,000
Contribution margin percentage          60%

Fixed costs
Rent$25,000
Utilities               $5,000
Wages$20,000
Total fixed costs                               $50,000
Net operating income$10,000

Contribution Margin Example

For example, Isabel is the CFO of a private company, the holding company for a series of retirement homes, called Retireco. She has known the owner of Retireco since she was a child, noticing her unique drive to make her company a success. Isabel has turned her family friend into a lifelong business connection and now, having earned her expertise in the accounting world, is her CFO.

One day the CEO of Retireco asks Isabel to calculate the CM of her company. Her purpose is to know variable costs, fixed costs, and finally profit are derived from sales. Since she is familiar with it, this is a simple task.

Isabel begins by collecting all of the company financial records. Once she has done this, she sits down to perform CM analysis. Here, she finds a per unit value:

$1,000 unit price and a $150 unit variable cost

CM = $1,000 – $150 = $850

Isabel then converts this number to CM ratio:

$1,000 unit price and a $150 unit variable cost

CM = ($1,000 – $150) / $1,000 = .85

Isabel now knows that 85% of sales can move on to cover fixed costs or become company profits. Therefore, she can provide this information to the Retireco CEO with suggestions for how to best use this money for these purposes. By having effective financial ratios, doors open which can lead to further growth of Isabel’s career and the company as a whole. Want to check if your unit economics are sound?  Download your free guide here.

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Cost Volume Profit Definition

See Also:
Prepare a Breakeven Analysis
Contribution Margin
How to Prepare an Investor Package
Capital Asset Pricing Model CAPM
Net Profit Margin Analysis
Cost Volume Profit Formula

Cost Volume Profit Definition

A cost volume profit definition, defined also as the CVP model, is a financial model that shows how changes in sales volume, prices, and costs will affect profits. Use the CVP analysis for planning, making projections, and for decision-making purposes. A CVP model can be used to calculate a breakeven sales volume. CVP analysis can also be used to figure out the sales volume required to reach a certain target profit.


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Cost Volume Profit Explanation

Cost volume profit, explained below, is one of the many ways to measure changes in the financial health of a company as it relates to sales. A CVP model is a simple financial model that assumes sales volume is the primary cost driver. In order to create a CVP model, you need certain data for the fiscal period in question. You need an estimate or figure for fixed costs, unit-level variable costs, and product/unit sales prices.

Cost Volume Profit Examples

For example, let’s take a movie theater in reference to a simple cost volume profit analysis. The theater has quarterly fixed costs of $30,000. These include utilities, salaries, and rent/mortgage, etc. The variable cost per movie ticket is $2. This includes the cost of paper, printing, and the custodial services, etc. The price of a movie ticket is $7.

Three variables:

1. Fixed costs of $30,000
2. Variable costs of $2
3. Sales price of $7

Now, using this data, we can calculate the breakeven point for the theater. Once you have this data, calculating the breakeven point is easy. First, compute the contribution margin per ticket. The contribution margin is the sales price minus the unit-level variable costs. Then find out how many tickets the theater must sell in order to cover its fixed costs. To do this, divide fixed costs by the contribution margin per ticket.

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cost volume profit definition

Source

Hilton, Ronald W., Michael W. Maher, Frank H. Selto. “Cost Management Strategies for Business Decision”, Mcgraw-Hill Irwin, New York, NY, 2008.

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Cost Volume Profit Formula

See Also:
Cost-Volume-Profit (CVP) Model

Cost Volume Profit Formula: Breakeven Sales Volume

Breakeven Sales Volume = Fixed Costs ÷ (Sales Price – Variable Costs)

Breakeven Sales Volume = Fixed Costs ÷ (Contribution Margin)

6,000 = $30,000 ÷ ($7 – $2)

6,000 = $30,000 ÷ ($5)

As you can see, the theater has a contribution margin of $5. That is, the theater makes five dollars per ticket sold. This contribution margin can be used to pay down the theater’s fixed costs. So we divide $30,000 of fixed costs by $5 contribution margin. This shows us that the theater must sell 6,000 tickets per quarter to break even. The cost volume profit equation shows us many important aspects of the business of the theater.

Now let’s say the theater doesn’t want to merely breakeven. They actually want to make a profit in the upcoming quarter. Selling 6,000 tickets allows them to breakeven. But how many do they need to sell in order to make a profit of, let’s say, $10,000? We can find out by using the CVP model and the CVP formula.

When performing CVP analysis in order to determine the sales volume required for a set target profit, you simply add the target profit to the fixed costs. So we have variable costs of $2, sales price of $7, and fixed costs of $30,000. And now we’re adding target profit of $10,000. Following is how we set up the CVP formula for a target profit.


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Cost Volume Profit Calculation: Target Sales Volume

Target Sales Volume = (Fixed Costs + Target Profit) ÷ (Sales Price – Variable Costs)

Target Sales Volume = (Fixed Costs + Target Profit) ÷ (Contribution Margin)

8,000 = ($30,000 + $10,000) ÷ ($7 – $2)

8,000 = ($40,000) ÷ ($5)

As you see here, the theater must sell 8,000 tickets in order to cover its fixed costs and make a profit of $10,000 in the upcoming quarter.

Of course, for illustrative purposes, this is a very simple example. Real-world examples may be more complex and have more variables. But this is a basic version of the cost-volume-profit financial model.

cost volume profit formula

cost volume profit formula

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How to Prepare a Break Even Analysis

Break even analysis, defined as the studying the path to the point where a company is neither losing money nor making a profit, is very important to the survival of any start-up business. Perform it for either products or the business as a whole. The break even calculation can be in reference to pro or post-forma, that is before or after the company has been formed.

Break Even Analysis Explanation

The break even analysis serves to provide the company with a very important piece of information:

“How much revenue does the firm need to make in order to break even?”

This break even analysis is quite easy to do. The only critical piece of information that you will need to attain is a breakdown of the your firm’s expenses into Fixed Expenses and Variable Expenses.

Once you have a breakdown of fixed costs and variable costs, input these costs into the template. You will also be able to conduct various “What if” scenario analyses to see how the breakeven revenue will change.

Once you are able to arrive at the break even analysis you can show the Owner(s)/Management this metric and make it part of their sales planning. Another idea might be to incorporate this metric into the Flash Report review meeting. This way your staff can know on a weekly basis if they are on track to at least breaking even. To learn how to price for profit, download our Pricing for Profit Inspection Guide.

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Warning Signs of a Company in Trouble

When considering an acquisition of, investment in, or employment with a company it is best for your peace of mind, as well as, financially to be aware of indications that the company’s true picture may not be what management would lead you to believe.

Warning Signs of a Company in Trouble

The surest sign that something is amiss is a frustrated stakeholder – be it the owner, investors, or lenders. What are their concerns? Have there been repetitive problems with the company? Does management not seem to have the right skill set to handle the most pressing issues? Does management spend too much time assessing blame and not a lot of time accurately identifying the company’s problems and devising solutions?

Where to Start

It is best to first take a look at the company’s financials. Start with the balance sheet. Are they building inventory and not able to sell it? Do they have a negative cash position? Have they maxed out their borrowing base? Also be sure that the balance sheet reflects the true state of affairs. For example, has the company written a check which it has yet to mail despite debiting its accounts payable account?

Take a look at the income statement, preferably one with monthly performance over the last 12 months. Group the items into three categories: sales, variable costs including direct sales costs, and fixed costs. What trends do you see in those categories? Perform a breakeven analysis. What is their contribution margin? Is it declining? What about EBIT? Is the company able to service its debt?

It can be helpful to simplify a company’s financial statements, combining similar items in order to move out of the detail and focus on the company’s overall performance and financial position.

The greatest mistake is not necessarily investing in a troubled company, but rather misdiagnosing the company’s problem(s).

Checklist

Here are some items to consider when performing diligence on a company:

Cash shortfall – does the company seem to be constantly in a cash crunch?

Physical deterioration of facilities – signs of inability to maintain facilities due to lack of proper planning and ability to re-invest.

Poor Accounting Systems – accounting records and reporting are delinquent. Often the company does not know if they are making money or losing money.

High concentration of leased assets – inability to secure traditional financing

If you want more tips on how to improve cash flow, then click here to access our 25 Ways to Improve Cash Flow whitepaper.

 

Warning Signs of a Company in Trouble
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Warning Signs of a Company in Trouble

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