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Variable vs Fixed Costs

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

Variable vs Fixed Costs Definition

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

All Costs

In accounting, all costs are either fixed costs or variable costs. Variable costs are inventoriable costs. That means accountants allocate fixed costs to units of production. Then they are 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.

Comparing Fixed Costs to Variable 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 no longer incurs the cost, then it is most likely a variable cost.

Variable vs Fixed Costs Examples

To further help explain these costs, find a couple variable vs fixed costs examples below.

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.

Variable vs Fixed 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, then the primary factors in this decision will be the variable or incremental costs of the production of additional units of output. It would not be 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.

If you want to utilize your unit economics to add more value to your organization, then click here to download the Know Your Economics Worksheet.

variable vs fixed costs, Variable vs Fixed Costs Examples, Variable vs Fixed Costs Definition

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Variable Cost

See Also:
How to Prepare a Break Even Analysis
Cheif Financial Officer (CFO)
Cost Accounting
Yield Curves
Financial Ratios
Absorption Cost Accounting

Variable Cost Definition

In accounting, variable costs are costs that vary with production volume or business activity. Variable costs go up when a production company increases output and decrease when the company slows production. These costs may also be called unit-level costs. Variable costs are in contrast to fixed costs, which remain relatively constant regardless of the company’s level of production or business activity. Combined, a company’s fixed costs and variable costs comprise the total cost of production.

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 various indirect costs and fixed manufacturing overhead costs. Variable costs include direct labor, direct materials, and variable overhead.

Variable Cost Example

For example, imagine a company that manufactures widgets. The company has a factory and laborers. The company purchases one unit of raw material for each widget it makes. Each widget requires one hour of labor. Each unit of raw material costs one dollar and each hour of labor costs $10.

This company’s variable costs, according to the example, would be the costs associated with purchasing raw material and the wages paid to laborers. When business is booming, the factory makes 1,000 widgets per day. Therefore, variable costs for raw materials and labor when business is good would be $1,000 for units of raw material and $10,000 for labor wages per day.

When business is slow, the company only makes 500 widgets per day. In this case, the daily raw material costs would be $500 and the daily labor costs would be $5,000. The variable costs associated with production fluctuate with the volume of production. More production volume means more variable costs, and less production volume means less variable costs.

Fixed costs, on the other hand, such as rent and utilities for the factory, remain constant whether the company is producing 1,000 widgets per day or 500 widgets per day. Fixed costs do not fluctuate with production volume.

Variable Costs and Decision-Making

When making production decisions, managers will often consider only the variable costs related with the decision. Since fixed costs will be incurred regardless of the outcome of the decision, those costs are not relevant to the decision. Only costs that will or will not be incurred as a direct result of the decision are considered. And these relevant costs are the variable costs.

If you want to find out more about how to utilize your unit economics to add more value to your organization, then click here to download the Know Your Economics Worksheet.

variable cost

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Segment Margin Example

See also:
Segment Margin
Margin vs Markup
Prepare a Breakeven Analysis
Budgeting 101: Creating Successful Budgets
Cost Volume Profit Definition
Variable vs Fixed Costs

Segment Margin Example

Segment Margin is important to a company because, most obviously, companies make profits off of their services and products. To acquire revenue from these services and products, a company would use a segment margin in order to determine whether the product has enough economical worth to continue producing. Therefore, it makes sense to provide an example so that segment margin can be viewed in a real life situation. An segment margin example is provided below.

Example And Explanation of Segment Margin

A shoe company, Fastbrink Shoes, has many different lines of shoe products and memorabilia that they sell to the public in order to make a profit. Because there are so many products, Fastbrink decides that they are going to trim down the number of products so that the most profitable and marketable products are getting the most attention. At the same time, they also want to eliminate the products that do not earn as much revenue as the more popular models and products. In one such case, Fastbrink has a line of basketball shoes that comes in two different colors, blue and black. Fastbrink wants to decide which shoe to keep and which shoe to scrap. Fastbrink will do this by calculating the segment margin for each shoe to determine which is the more profitable.

Segment Margin Calculation

It must be noted, first of all, that segment margin is calculated by taking the segment revenue of a product. This is essentially the revenue that is produced by a single product by itself. You then subtract the variable costs from the segment revenue and finally subtract the total avoidable fixed costs from that number to decipher the segment margin of a product. For this situation, the segment revenue for the blue shoe is $40,000 for the quarter while the revenues for the black shoe total $35,000. The variable costs for the blue and black shoes are $13,000 and $10,000 respectively. Finally, the avoidable fixed cost for both shoes is $10,000 for labor, parts, and machine maintenance. When calculated completely, the segment margin for the blue shoe comes out to be $17,000. Whereas, the black shoe segment margin totals $15,000.

Because the blue shoe rakes in $2,000 dollars more revenue that the black shoe, Fastbrink decides to discontinue the black shoe. As a result, profits on the blue shoe (more profitable model) can be maximized.

If you want to learn how to shape your economics to result in profit, then click here to download the Know Your Economics Worksheet.

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Segment Margin

See Also:
Segment Margin Example
Segmenting Customers for Profit
Net Profit Margin Analysis
Operating Profit Margin Ratio
Margin vs Markup
Profitability Index Method

Segment Margin Definition

Segment margin is a measure of profitability that applies to individual product lines. It is calculated as segment revenues minus variable costs minus avoidable fixed costs. It is also used to measure the profitability of a segment or product line when you make the decision of whether to continue or discontinue that segment or product line.

Segment Margin Calculation

Use the following formula to calculate segment margin:

SM = Segment Revenues – Variable Costs – Avoidable Fixed Costs

Segment Margin and Decision-Making

Segment margin separates relevant costs from irrelevant costs when analyzing a product line. For instance, if management is deciding whether to continue or discontinue a product line, the appropriate calculation for measuring the relevant revenues and relevant expenses for the decision would be to use this type of margin.

The difference between segment margin and other measures of profitability, such as contribution margin, is that it divides fixed costs into three categories. Consider one of the categories of fixed costs relevant when making decisions about the segment in question; the other two categories of fixed costs are irrelevant.

Segment Margin and Fixed Costs

The three categories include the following: avoidable fixed costs, unavoidable fixed costs, and common expenses. Avoidable fixed costs are relevant in the decision-making process of whether to continue or discontinue a product line. Whereas, unavoidable fixed costs and common expenses are irrelevant for decisions regarding a particular product line.

Avoidable fixed costs are those fixed costs that would not incur if you eliminated the segment or product line. Unavoidable fixed costs are fixed costs necessary for the continuation of the segment or product line. But those fixed costs would still incur if you discontinued that segment or product line. Eliminating the segment in question would merely cause the allocation of these unavoidable fixed costs to another segment. Refer to common expenses as expenses incurred by the company as a whole that are allocated to various segments or product lines.

If you want to increase the value of your organization, then click here to download the Know Your Economics Worksheet.

segment margin

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segment margin

Source:

Barfield, Jesse T., Michael R. Kinney, Cecily A. Raiborn. “Cost Accounting Traditions and Innovations,” West Publishing Company, St. Paul, MN, 1994.

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Semi Variable Costs

See Also:
Variable vs Fixed Cost
Absorption vs Variable Costing
Product Costs vs Period Costs
Sunk Costs
How to Estimate Expenses for an Annual Budget

Semi Variable Costs Definition

Semi variable costs are costs that include both a fixed and a variable component. They are also called mixed costs.

Semi Variable Cost Example 1

For example, let’s say you subscribe to a phone service that charges $40 dollars per month, plus $0.10 per minute for each additional minute beyond 500 minutes per month.

If you talk for less than 500 minutes per month, then the cost is $40 dollars per month. Beyond 500 minutes, the cost increases. This is an example of a semi variable cost. The flat rate of $40 dollars for 500 minutes is the fixed cost component. The additional $0.10 per minute for each additional minute beyond 500 minutes is the variable cost component.

Semi Variable Cost Example 2

Here is an example of a slightly different type of semi variable cost. For example, let’s say a manufacturing company has an electric bill that uses semi variable cost, including a fixed cost component and a variable cost component.

The electric company charges the manufacturing company a flat monthly rate of $300 dollars per month for basic electricity service. Then they charge $0.015 per kilowatt hour (kwh). In this example, the flat rate of $300 dollars per month is the fixed cost component. And the variable cost component is $0.015 per kwh.

If the manufacturing company uses 50,000 kwhs of electricity in a particular month, then its electric bill would be $1,050 dollars. ($1,050 = $300 + ($0.015 x 50,000kwhs)). And if the manufacturing company uses 100,000 kwhs of electricity the following month, then its electric bill would be $1,800 dollars. ($1,800 = $300 + ($0.015 x 100,000kwhs)).

Accounting Treatment

Cost accountants typically separate semi variable costs into their two distinct components – the fixed cost component and the variable cost component – when dealing with semi variable costs. Treat the fixed cost component separately as a fixed cost. Then treat the variable cost component separately as a variable cost. This may cause a differentiation of cost that does not reflect economic reality, but it makes it easier to handle and examine the effects of semi variable costs.

semi variable costs, Semi Variable Cost Example, Semi Variable Cost Definition

Source:

Barfield, Jesse T., Michael R. Kinney, Cecily A. Raiborn. “Cost Accounting Traditions and Innovations,” West Publishing Company, St. Paul, MN, 1994.

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Standard Cost

Standard Costs Definition

Standard cost accounting is a goal or budget costs that is associated with variable costs. They are also used to measure the cost that management believes that it will incur over a period.

Standard Costing Explained

In short, standard costing takes the direct labor, direct materials, and manufacturing overhead, and estimates the cost over a quarter, year, or whatever the period may be. This is similar to budget costing, but is different in that budget costs account for a total cost while a standard cost estimate is on a per unit basis. Therefore, if a standard cost estimate turns out to be correct, then the total cost would turn out to be equal to the budget cost. But, this sort of thing never happens.

Standard Cost Formula

The standard cost method can be broken down using the following formula:

Standard Costs = Direct Labor * Direct Materials * Manufacturing Overhead

Where:
Direct Labor = Hours Worked * Hourly Rate

Direct Materials = amount of materials * market price

Manufacturing Overhead = Fixed Salary + (Machine hours * Machine rate)

Note: All but the fixed salary component of overhead must be predicted given the market conditions on demand and cost of the materials. It should also be noted that this is the same formula for the manufacturing costs, but the difference lies in the fact that Standard costs accounting is done on a predictive basis.

Standard Cost Example

For example, Jenny is an accountant. Her boss, Craig the CFO, gave her a task to calculate the standard cost of the company for the upcoming year 2010. She was given the following past information for Wawadoo Co. to try and calculate the standard cost for Wawadoo’s product (widget).

Direct Labor-2009
AVg. Labor Hours= 1,960 hours per employee
Avg. Hourly Wage – $10
Number of employees = 47
Total Costs= $92,120

Direct Materials-2009
Material Units=20,000
Avg. Market Price= $20
Total Cost= $400,000

Overhead-2009
Fixed Salary per Manager= $80,000
Number of Managers= 5
Number of Machine hours= 1,000
Hourly Machine rate= $2
Total Cost=$410,000

Jenny’s Boss, Craig, believes that the overall demand for widgets will increase by 5% and the price and number of units needed will increase by the same amount. He also believes that there will be a need for 8 new employees as well as a new manager.

Jenny finds the following:

Direct Labor= 1,960 hrs.* $10/hr* 55 employees= $1,078,000
Direct Material = $21 mkt price* 21,000 units= $441,000
Overhead= ($80,000* 6) + (1,000 hrs.* $2/hr* 6) = $492,000

Total Standard Cost= $2,011,000 cost for the year

standard cost

See Also:
Manufacturing Cost
Cost of Goods Sold (COGS)
Overhead Definition
Direct Cost vs. Indirect Cost
Variable Cost

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Operating Leverage

See Also:
Homemade Leverage
Valuation Methods
Financial Ratios
Operating Profit Margin Ratio
Operating Cycle
What Your Banker Wants You to Know

Operating Leverage Definition

Operating leverage is a measure of the combination of fixed costs and variable costs in a company’s cost structure. A company with high fixed costs and low variable costs has high operating leverage; whereas a company with low fixed costs and high variable costs has low operating leverage.

High and Low Operating Leverage

A company with high operating leverage depends more on sales volume for profitability. The company must generate high sales volume to cover the high fixed costs. In other words, as sales increase, the company becomes more profitable. In a company with a cost structure that has low operating leverage, increasing sales volume will not dramatically improve profitability since variable costs increase proportionately with sales volume.

Contribution Margin and Breakeven Point

This term relates directly to a company’s contribution margin and breakeven point. Contribution margin is essentially a product’s selling price minus its unit-level variable cost. A product with proportionately less variable cost has a higher contribution margin. Hence, a product with a higher contribution margin corresponds with a production process that has high operating leverage – or higher fixed costs in relation to variable costs.

Similarly, a company with a high breakeven point has high operating leverage. The breakeven point refers to the level of sales volume at which per-unit profits fully cover fixed costs of production. In other words, it is the point at which revenues equal costs. Because more fixed costs translate into a higher breakeven point – more sales volume is required to cover the fixed costs – a production process with a high breakeven point utilizes high operating leverage. Of course, when a company with high operating leverage and a high breakeven point reaches sales volumes that exceed the breakeven point, a greater proportion of revenues generating are pure profit.


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Degree of Operating Leverage

The degree of leverage of a company’s cost structure is a ratio that measure’s the sensitivity of profits to changes in sales volume. In other words, this measures the degree to which a change in sales impacts profitability. In a company with high leverage, changes in sales volume magnify changes in profitability. Whereas in a company with low leverage the effects of fluctuations in sales volume impact profitability to a smaller degree. Divide the percentage change in the operating income by the percentage change in sales volume to find the degree of operating leverage. Use the following formula:

Degree of Operating Leverage = % Change in Operating Income ÷ % Change in Sales Volume

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Operating Leverage
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Operating Leverage

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