Fixed Costs Essay

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Total fixed costs are constant over a defined time period. Examples might include certain salaries and wages, depreciation, insurance premiums, heating, rental charges, property taxes, and fixed interest charges. They are “fixed” only in the sense that they do not vary in total with the short-term planned activity levels of the organization. In the long term, all costs are variable since they can be adjusted to new levels of activity following expansion or contraction.

Many costs are partially fixed. A telephone bill may contain a fixed equipment rental element and a variable call charge. Although fixed costs do not vary with activity, they can be changed by management action. Staff can be recruited or dismissed, depreciation policies can be changed, reward systems may change, insurance can be switched to more competitive suppliers, etc. A policy decision is required by management to alter the cost structure of the business. For example, managers may change payment of the sales force from salary to a salary-plus-commission basis. The total amount paid to the sales force may increase or decrease or even stay the same, but payment will now be part fixed and part variable.

Variable costs vary in direct relationship with changes in an identified causal factor (driver). So, twice as much glass is used to produce two cars as one. Fixed costs remain unaltered despite changes in their identified causal factors. Thus, the cost of employing a pension administrator will be the same whether there are 150 or 200 on the payroll. The level of variable costs is largely a technical matter—the cost of glass will be a function of the number of cars produced. But the level of fixed costs will largely be a matter of discretion for management. There may come a point at which there are not enough people on the payroll to justify a pension administrator and managers may decide to outsource this work. In general terms, when scale or activity in the causal factors change, total fixed costs will remain unchanged but unit fixed costs will change (total fixed costs divided by total units of causal factor).

The reverse is true of variable costs. Within the range of planned activity (the relevant range) for a given configuration of land, labor, and capital, fixed costs will not vary. If the scale or arrangement of this configuration is changed, then the cost structure of the business changes and will need to be redefined for business control purposes. The operational gearing or leverage of the firm describes its cost structure as a ratio between revenue minus variable cost and its profit. The higher the proportion of fixed costs in its cost structure, the higher will be the firm’s operational gearing ratio. The higher the ratio, the more exposed is the firm to large swings in profitability as market conditions change.

The behavior of fixed costs in relation to increasing levels of output is a source of scale economies. It is also a principal feature of a number of important management accounting decision support techniques. Cost-volume-profit analysis focuses on the break-even level of output which a firm must achieve to cover its total fixed costs. Only after this level does the firm achieve profits. Contribution analysis is used to optimize the use of productive resources when in short supply. Contribution is defined as price minus unit variable cost. The residual represents a contribution to the fixed costs of the business. The purpose is to maximize the contribution these scarce resources (or limiting factors) make to the firm’s fixed costs.

This form of analysis is also used for make-or-buy decisions, or decisions whether to accept special orders on terms that do not fully recover total accounted costs. This situation might arise when the firm has idle capacity. In such situations the important point is to consider only the relevant costs. In deciding to accept a contract at a discounted price, the fixed costs are irrelevant to the decision since they will not change whatever decision transpires. Provided the discounted price covers the variable cost involved in production and distribution of the contract volume, the business will be better off accepting it and making some contribution to its fixed costs. The differentiation between fixed and variable costs provides the basis for flexible budgeting. Budgets are set with an assumed level of output. In reality this level changes and the budget will be flexed with the variable element changing in relation to the actual level of activity, the fixed level remaining unaltered.

Bibliography:

  1. Robert J. Carbaugh, Contemporary Economics: An Applications Approach (M.E. Sharpe, 2008);
  2. David Donaldson and Krishna Pendakur, “The Identification of Fixed Costs from Consumer Behavior,” Journal of Business and Economic Statistics (v.24/3, 2006);
  3. Colin Drury, Management and Cost Accounting (South-Western, 2008);
  4. Sasha Galbraith, Anatomy of a Business: What It Is, What It Does, and How It Works (Greenwood Press, 2007);
  5. Charles T. Horngren et al., Introduction to Management Accounting (Pearson Prentice Hall, 2008).

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