The total cost of a product can be segregated into two broad components: fixed costs and variable costs. Unlike fixed costs, which are constant for a given time period, variable costs change proportionally to the volume of the production units. Variable costs can be defined as those costs that vary in direct proportion to the quantity of output.
Such a classification of cost is done in a marginal costing system where costs are segregated into fixed and variable costs to compute the break-even point (level of operation where there is no profit and no loss) and margin of safety (the actual level of production less the break-even point). Variable costs can be labor costs, material costs, or overhead costs. Material costs and direct labor costs (those labor costs that are directly related to production) are variable costs as these costs vary directly with output. Examples of variable costs are packaging material costs, fuel cost for a transport company, and so forth. Variable cost is not the same for all firms in an industry. It depends on many factors such as size of the firm (large firms may have lower variable costs because of economies of scale), strategy of firm (self-production or subcontract), and so forth.
Certain costs that are currently fixed in nature can be turned into variable costs and vice versa. For example, by subcontracting the loading and unloading activity that was earlier done by permanent employees, a firm will have to pay a charge based on the actual volume instead of the fixed wages to the current employees. Similarly, costs that are variable in nature can be converted to fixed costs. For example, a firm that was earlier selling its products through retailers had to pay a fixed commission (margin) to the retailer. If the firm starts selling its products through its own retail outlets or through the internet, the costs become fixed, as they need to pay rental, salary, and other costs. One of the reasons for cheaper prices over the internet than at retail outlets is that while the company saves significantly in terms of commission and other selling expenses, the fixed costs are also very low.
Dell is able to auction its products online at a cheaper price because it saves in variable costs such as dealer’s commission, store expenses, and so forth. Further, since Dell auctions huge quantities at a time, the fixed costs per unit decrease significantly. The e-tickets concept became so popular because airlines can save the variable costs that were earlier incurred in printing tickets, commission to airline agents, and so forth. Such benefits ultimately were transferred to the customers.
Furthermore, there are certain costs that are fixed up to a certain minimum level of production (fixed cost) and become variable after a particular level. For example, electricity charges are subject to a minimum fixed charge + a variable component for each unit consumed after a certain minimum level. Such costs are classified as semi variable costs.
In a continuing business, the cost incurred to produce an additional unit of output is the variable cost only because fixed cost is constant irrespective of the output. Unlike variable cost, an increase in output implies decrease in fixed cost per unit. The difference between sale price per unit and the variable cost per unit is termed contribution per unit. It is called so because it signifies how much the sale of an additional unit contributes to the fixed costs and profits of the business. So long as the contribution is positive, the profit of a firm can be increased by increasing the sales volume. It is always advisable to discontinue operations if the contribution per unit is negative because it implies increasing loss with each additional unit of output.
Break-even point is computed by dividing the total fixed costs by the contribution per unit. Sale quantity greater than break-even point implies net profit and sale quantity less than the break-even point implies net loss.
Estimating the variable cost per unit is very important while bidding for supply to any bulk buyers or for a one-time contract where a discounted sale price is not going to affect the sale price to other existing customers. In case we have unused installed capacity, any sale price above the total variable costs will result in increase in net profit of a firm. This is because the additional revenue (bulk order price x bulk order quantity) will be greater than the additional costs (variable costs x bulk order quantity). Therefore, the bid price should consider only the variable cost and not the total cost of the product.
- Robert N. Anthony, David F. Hawkins, and Kenneth A. Merchant, Accounting: Text and Cases (McGraw-Hill Irwin, 2007);
- Srikant M. Datar et al., Cost Accounting: A Managerial Emphasis (Pearson/Prentice Hall, 2009);
- Richard Edwards, The History of Cost and Management Accounting: The Experience of the United Kingdom (Routledge, 2009);
- Craig Newmark, Readings in Applied Microeconomics: The Power of the Market (Routledge, 2009);
- Peter Whittle, Networks: Optimisation and Evolution (Cambridge University Press, 2007).
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