Cost classifications: Fixed and variable costs
In cost accounting, classifying costs is a fundamental activity. Being able to separate and distinguish costs has allowed managers to understand, control and predict cost behaviour. Therefore, management accountants would be interested in examining how cost responds to changes in the level of activity. In the sphere of cost behaviour, fixed costs and variable costs are the two dominant concepts.
- Total Cost = Fixed Costs + (Variable Cost per unit x Output)
- Fixed costs are constant whatever the activity level
- Variable costs vary with output
Technically, no cost is likely to remain fixed over a lengthy period; in the long run, all costs are variable costs. For example, insurance for a period is regarded as a fixed cost, but it can change for the following period. If we are examining cost behaviour over time, insurance premiums might are variable.
To cater for the fact that all costs vary over time, fixed costs are better known as “period charges.” A more robust definition of fixed costs posits that they are attached to a specific period and remain constant within specific levels of activity. Some examples of fixed costs include machinery, rent, straight-line depreciation and salaries (as opposed to wages).
Variable costs can be thought of as the aggregate of all marginal costs over total production. They include direct materials used in production, commissions and overtime payments. Not all costs can be neatly classified as either fixed or variable – even in a specific period. Such costs are semi-fixed or semi-variable, having properties of both types of cost. Utilities are a common example of a semi-variable cost, since there is a fixed charge and then additional charges according to consumption/usage.
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As mentioned earlier, costs vary with activity in the long run. However, some costs actually change once a certain activity level is passed and remain fixed for that level of activity. Such costs are regarded as step costs.
A good example of a step cost is the cost of supervision for a production process. If 10 supervisors are needed for every 10,000 units produced, when the activity levels surpass that, another batch of supervisors would be required.
In the basic graphs for total costs, Total Fixed Costs (TFC) are represented by a line parallel to the x-axis while the Total Variable Costs (TVC) line intersects the y-axis at zero. However, fixed costs per unit and variable costs per unit behave differently.
Fixed costs per unit (Average fixed costs) decrease as activity increases. This is because the same cost is spread over a larger volume of output. On the other hand, variable costs per unit (Average variable costs) remain constant, since the marginal cost per unit is constant. Note that the break-even point is where the marginal cost equals the average total cost.
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