Fixed and variable costs
The following report aims to explore and analyse the possibility of all costs being either fixed or variable. The concept that costs are either one or the other gives certain doubt whether the terms ‘semi-variable' or ‘semi-fixed' costs are without a doubt useful. In order to present a precise argument in favour of the original question, it is very important to identify the fixed and variable costs and their main differences.
According to Drury (2008), short term variable costs ‘vary in direct proportion to the volume of activity', that is, doubling up the level of activity will double the total variable cost. The author additionally argues that total variable costs are linear and unit variable costs are stable. Effectively, it is unlikely that variable cost per unit will be invariable for all levels of activity. Examples of short-term variable manufacturing costs include labour, direct materials and power to function the equipment. The important factor about these costs is the fact that they are thought to vary directly equally balanced to operating activity within a certain range of activity. Alternatively, it can be argued that non-manufacturing costs could include sales commissions, which rise and fall with sales price, and petrol, which changes with the number of miles travelled.
Wheetman (2006) states ‘a fixed cost is one which is not affected by changes in the level of activity over a defined period of time', even though the author also argues that this may change in the longer term – for example rent, might be fixed for a period of one year, but may then be problem to be reviewed at the end of every year. In addition to this, total fixed costs are stable for all levels of activity while unit fixed costs decrease proportionally with the level of activity. For example, if the total fixed costs are £15000 for a month, the fixed costs per unit will diminish proportionally to the raise of the number of units produced. Consequently, if the number of units produced were to increase from one to ten, the fixed cost per unit would for that reason decrease from £15000 to £1500.
The most essential and key factor in relation to fixed and variable costs is the fact that the difference between them must be made in relation to the time period under deliberation. Over a adequately long time period of several years, it could be disagreed between parties that all costs are variable. During such a long period of time, tightening in demand will be gone along with reductions in practically all categories of costs. For example, senior managers can be set free, machinery need not be replaced and even buildings and lands can be sold. Correspondingly, large expansions in activity will ultimately cause all categories of costs to rise. Within shorter time periods, costs will be fixed or variable in relation to changes in activity. The shorter the time period, the greater the possibility that a certain cost will be fixed. An example of this is a time period of one year, whereby the costs of providing the firm's operating capability such as depreciation and the salaries of senior managers are likely to be fixed no matter to changes in activity. Decisions on the firm's proposed future prospective level of operating capacity will determine the amount of capacity costs to be acquired. These decisions will have been made previously as part of the capital budgeting and long-term planning process. (Drury 2003). Once these decisions have been made, they cannot easily be inverted in the short-term. Plant investment and desertion decisions therefore should not be based on short-term fluctuations in demand within a particular year. Instead, they should be reviewed at regular intervals as part of the long-term planning process and decisions made based on long-run demand over several years. Thus, capacity costs will be inclined to be fixed in relation to changes of activity within short-term periods; such as one year. However, over long-term, period of several years, important changes in demand will cause capacity costs to change.
The points of view above without a doubt show that all costs may be either fixed or variable; however this will only be true within a certain timescale. On the other hand, for the benefit of independence, it is equally important to admit and draw attention to the fact that costs may also be either ‘semi-fixed' or ‘semi-variable'. In the case of the previous topic, for example, spending on some fixed costs, such as direct labour and supervisory salaries, can be adjusted in the short term to reflect changes in activity. For example, if production activity decreases significantly then direct employees and employers might continue to be employed in the hope that the decline in demand will be temporary; but if there is no upsurge in demand then staff might eventually be laid off. If, on the other hand, manufacturing capacity expands to some critical level, additional workers might be employed, but the process of hiring such workers may take several months. Therefore within a short-term period, such as one year, labour costs can change in response to changes in demand. Consequently, the characteristic feature of semi-fixed costs is that within a given time period they are fixed within specified activity levels, but they will sooner or later rise or fall by a stable amount at various critical activity levels.
Semi-variable costs should not be mistreated in general either. These costs include both a fixed and a variable section. The cost of maintenance is a semi-variable cost consisting of considered maintenance that is assumed whatever the level of activity, and a variable element is directly related to the level of activity. An additional example of semi-variable costs is where sales legislative bodies are paid a fixed income plus a commission on final transaction.
In conclusion, it should be noted that costs may indeed be either fixed or variable depending in what context they are related to. To be more accurate, the time scale is of highest importance when taking in to consideration these factors. Having mentioned the probability of the incidence and their frequency in the modern business world, one also has to be aware of the fact that semi-fixed and semi-variable costs are not non-existent and may also be present in the operations of various firms.
- Drury, C. (2008), Management and Cost Accounting, 7th edition, London: Thompson Business Press (Students who wish to gain additional practice with numerical examples are advised to purchase the Students' Manual, which accompanies the Drury text. The manual has the same title and publisher as the textbook, and is available from the University Bookshop).
- Hyndman, N. and McKillop, D. (2006), Cases in Management Accounting and Business Finance, Dublin, Institute of Chartered Accountants in Ireland.
- Hopper, T., D. Northcott and R. Scapens (2007), (eds), Issues in Management Accounting, 3rd edition, FT Prentice Hall.