The total cost of a business is composed of fixed costs and variable costs. Fixed costs and variable costs affect the marginal cost of production only if variable costs exist. The marginal cost of production is calculated by dividing the change in the total cost by a one-unit change in the production output level. The calculation determines the cost of production for one more unit of the good. It is useful in measuring the point at which a business can achieve economies of scale.
A fixed cost is a cost that remains constant; it does not change with the output level of goods and services. It is an operating expense of a business, but it is independent of business activity. An example of fixed cost is a rent payment. If a company pays $5,000 in rent per month, it remains the same even if there is no output for the month. Conversely, a variable cost is dependent on the production output level of goods and services. Unlike a fixed cost, a variable cost is always fluctuating. This cost rises as the production output level rises and decreases as the production output level decreases. For example, say a company owns a manufacturing plant and produces toys. The electricity bill varies as the production output level of toys varies. If no toys are produced, the company spends less on the electricity bill. If the production output of toys increases, the cost of the electricity increases. The marginal cost of production is an economics and managerial accounting concept most often used among manufacturers as a means of isolating an optimum production level. Manufacturers often examine the cost of adding one more unit to their production schedules. At a certain level of production, the benefit of producing one additional unit and generating revenue from that item will bring the overall cost of producing the product line down. The key to optimizing manufacturing costs is to find that point or level as quickly as possible. Marginal cost of production includes all of the costs that vary with that level of production. For example, if a company needs to build an entirely new factory in order to produce more goods, the cost of building the factory is a marginal cost. The amount of marginal cost varies according to the volume of the goods being produced. It is not necessarily better or worse for a company to have either fixed costs or variable costs, and most companies have a combination of fixed costs and variable costs. A company with greater variable costs compared to fixed costs shows a more consistent per-unit cost and, therefore, a more consistent gross margin, operating margin, and profit margin. A company with greater fixed costs compared to variable costs may achieve higher margins as production increases since revenues increase but the costs will not. However, the margins may also reduce if production decreases. Although the marginal cost measures the change in the total cost with respect to a change in the production output level, a change in fixed costs does not affect the marginal cost. For example, if there are only fixed costs associated with producing goods, the marginal cost of production is zero. If the fixed costs were to double, the marginal cost of production is still zero. The change in the total cost is always equal to zero when there are no variable costs. The marginal cost of production measures the change in total cost with respect to a change in production levels, and fixed costs do not change with production levels. However, the marginal cost of production is affected when there are variable costs associated with production. For example, suppose the fixed costs for a computer manufacturer are $100, and the cost of producing computers is variable. The total cost of production for 20 computers is $1,100. The total cost for producing 21 computers is $1,120. Therefore, the marginal cost of producing computer 21 is $20. The business experiences economies of scale because there is a cost advantage in producing a higher level of output. As opposed to paying $55 per computer for 20 computers, the business can cut costs by paying $53.33 per computer for 21 computers.
The term fixed cost refers to a cost that does not change with an increase or decrease in the number of goods or services produced or sold. Fixed costs are expenses that have to be paid by a company, independent of any specific business activities. This means fixed costs are generally indirect, in that they don't apply to a company's production of any goods or services. Companies can generally have two types of costs—fixed or variable costs—which together result in their total costs. Shutdown points tend to be applied to reduce fixed costs.
The costs associated with doing business can be broken out by indirect, direct, and capital costs on the income statement and notated as either short- or long-term liabilities on the balance sheet. Both fixed and variable costs make up the total cost structure of a company. Cost analysts analyze both fixed and variable costs through various types of cost structure analysis. Costs are generally a key factor influencing total profitability. Fixed costs are those that don't change over the course of time. They are usually established by contract agreements or schedules. These are the base costs involved in operating a business comprehensively. Once established, fixed costs do not change over the life of an agreement or cost schedule.
Fixed costs are allocated in the indirect expense section of the income statement which leads to operating profit. Depreciation is one common fixed cost that is recorded as an indirect expense. Companies create a depreciation expense schedule for asset investments with values falling over time. For example, a company might buy machinery for a manufacturing assembly line that is expensed over time using depreciation. Another primary fixed, indirect cost is salaries for management.
Any fixed costs on the income statement are accounted for on the balance sheet and cash flow statement. Fixed costs on the balance sheet may be either short- or long-term liabilities. Finally, any cash paid for the expenses of fixed costs is shown on the cash flow statement. In general, the opportunity to lower fixed costs can benefit a company’s bottom line by reducing expenses and increasing profit. Fixed costs can be used to calculate several key metrics, including a company's breakeven analysis and operating leverage. A breakeven analysis involves using both fixed and variable costs to identify a production level in which revenue equals costs. This can be an important part of cost structure analysis. A company’s breakeven production quantity is calculated by: Breakeven Quantity = Fixed Costs ÷ (Sales Price per Unit – Variable Cost per Unit A company’s breakeven analysis can be important for decisions on fixed and variable costs. The breakeven analysis also influences the price at which a company chooses to sell its products. Operating leverage is another cost structure metric used in cost structure management. The proportion of fixed to variable costs influences a company’s operating leverage. Higher fixed costs help operating leverage to increase. You can calculate operating leverage using the following formula: Operating Leverage = [Q x (P - V)] ÷ [Q x (P - V) - F] Where:
Companies can produce more profit per additional unit produced with higher operating leverage. As noted above, fixed costs are any expenses that a company incurs that never change during the course of running a business. Fixed costs are usually negotiated for a specified period but can't decrease on a per unit basis when they are associated with the direct cost portion of the income statement, fluctuating in the breakdown of costs of goods sold.
Variable costs, on the other hand, are costs directly associated with production and therefore change depending on business output. These costs can increase or decrease with respect to production levels or sales. Variable costs are generally associated with things like raw materials and shipping costs.
Companies have some flexibility when it comes to breaking down costs on their financial statements, and fixed costs can be allocated throughout their income statement. The proportion of fixed versus variable costs that a company incurs and its allocations can depend on its industry. Companies can associate fixed (and variable) costs when analyzing costs per unit. As such, the cost of goods sold (COGS) can include both types of costs. All costs directly associated with the production of a good are summed collectively and subtracted from revenue to arrive at gross profit. Cost accounting varies for each company depending on the costs they are working with. Economies of scale can also be a factor for companies that can produce large quantities of goods. Fixed costs can be a contributor to better economies of scale because fixed costs can decrease per unit when larger quantities are produced. Fixed costs that may be directly associated with production will vary by company but can include costs like direct labor and rent. In addition to financial statement reporting, most companies closely follow their cost structures through independent cost structure statements and dashboards.
Independent cost structure analysis helps a company fully understand its fixed and variable costs and how they affect different parts of the business as well as the total business overall. Many companies have cost analysts dedicated solely to monitoring and analyzing the fixed and variable costs of a business. The fixed charge coverage ratio, on the other hand, is a type of solvency metric that helps analyze a company’s ability to pay its fixed-charge obligations. The fixed-charge coverage ratio is calculated from the following equation: (EBIT + Fixed Charges Before Tax) ÷ (Fixed Charges Before Tax + Interest)
The fixed cost ratio is a simple ratio that divides fixed costs by net sales to understand the proportion of fixed costs involved in production. Fixed costs include any number of expenses, including rental lease payments, salaries, insurance, property taxes, interest expenses, depreciation, and potentially some utilities.
For instance, someone who starts a new business would likely begin with fixed costs for rent and management salaries. All types of companies have fixed cost agreements that they monitor regularly. While these fixed costs may change over time, the change is not related to production levels but are instead related to new contractual agreements or schedules.
Common examples of fixed costs include rental lease or mortgage payments, salaries, insurance payments, property taxes, interest expenses, depreciation, and some utilities.
All sunk costs are fixed costs in financial accounting, but not all fixed costs are considered to be sunk. The defining characteristic of sunk costs is that they cannot be recovered. It's easy to imagine a scenario where fixed costs are not sunk. For example, equipment might be resold or returned at the purchase price. Individuals and businesses both incur sunk costs. For example, someone might drive to the store to buy a television, only to decide upon arrival to not make the purchase. The gasoline used in the drive is, however, a sunk cost—the customer cannot demand that the gas station or the electronics store compensate them for the mileage.
Fixed costs are associated with the basic operating and overhead costs of a business. Fixed costs are considered indirect costs of production, which means they are not costs incurred directly by the production process, such as parts needed for assembly, but they do factor into total production costs. As a result, they are depreciated over time instead of being expensed.
Unlike fixed costs, variable costs are directly related to the cost of production of goods or services. Variable costs are commonly designated as the cost of goods sold, whereas fixed costs are not usually included in COGS. Fluctuations in sales and production levels can affect variable costs if factors such as sales commissions are included in per-unit production costs. Meanwhile, fixed costs must still be paid even if production slows down significantly. |
Decisions about whether to use fixed or variable costs to run a business impact a companys ______.
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