Definition of fixed cost and variable cost
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Published: Mon, 5 Dec 2016
Fixed cost (FC): is a cost that remains constant, in total, regardless of changes in the level of activity. Fixed costs are not affected by changes in activity. Consequently, as the activity level rises and falls, total fixed costs remain constant unless influenced by some outside force. But fixed cost per unit decreases as the activity level rises and increases as the activity level falls. (Garrison etal., 2006, P49). Fixed costs include salaries of executives, interest expense, rent, depreciation, and insurance expenses. .
Variable cost (VC): is a cost that varies, in total, in direct proportion o changes in the level activity. The activity can be expressed in many ways, such as units produced, units sold, miles driven, beds occupied, lines of print, hours worked and so forth. But variable cost per unit remains constant. ((Garrison etal., 2006, P48).
Direct cost, indirect cost and overhead costs
Direct costs: is a cost that can be easily and conveniently traced to the particular cost object under consideration. The concept of direct cost extends beyond just direct materials and direct labor. (Garrison etal., 2006, P50). Example: the salary of supervisor in marketing department is the direct cost for marketing department. The salary is likely the same each month not depend on the quantity of sales product.
Indirect costs: is a cost that cannot be easily and conveniently traced to the particular cost object under consideration. (Garrison etal., 2006, P50). Each business has its own method of allocating indirect costs to different products, sources of sales revenue and business units. Business managers and accounts should always keep an eye on the allocation methods used for indirect costs. Example: Depreciation on the production machine is also an indirect product cost, it stays the same each year not depend on the volume produced on the machine.
Costs can be direct and indirect depending on the cost object: product, department, and others such as division, customer, or geographic market. The total amount of the cost remain the same as volume changes, it is fixed cost. It is a variable cost if the total cost change in proportion to the change in the activity or volume.
Overhead costs: the indirect recurring costs of running a business that are not linked directly to the goods or service produced and sold. Overhead costs can include payments for the rent of premises, utility bills, and employees’ salaries.
Controllable costs and uncontrollable costs
Controllable cost: are those costs which can be regulated or controlled by specified member of an undertaking. Most of the variable costs are controllable costs. For example, direct material, direct labor and direct expenses â€¦are controlled by the lower level of management.
Uncontrollable cost: can not be controlled by the specified member of the undertaking. Most of the fixed costs are uncontrollable cost. For example, factory rental expense, supervisor’s salary, depreciation.
Evaluate the statement
“I have trouble with the terminology-direct costs, also called variable costs, are the ones that are controllable. Whereas indirect costs or overheads, also called fixed costs, are uncontrollable”.
Based on the definitions above, I strongly disagree with the statement because the delegate assumed wrongly about the cost. There are many ways to classified cost depending on the purpose of management.
According to association with products, costs are divided into product costs and period costs.
According to identifiably, costs are divided into direct cost and indirect cost.
According to behavior, costs are divided into fixed cost, variable cost and semi- variable cost.
According to controllability, costs are divided into controllable costs and uncontrollable costs.
Direct cost can be fixed cost and variable cost depending on situations
For example: the salary of supervisor in manufacture department is the direct cost for manufacture department. The salary is likely the same each month not depend on the quantity of product. It is a fixed cost of manufacture department. Raw material supply for manufacture department is a direct cost for department but it is a variable cost, total amount of supplies use in the department increases if the volume in the department increases.
Indirect costs can be fixed costs and variable cost also:
In opposition to direct cost, most of indirect cost is fixed cost. For example rental cost is indirect cost for part production, it is a fixed cost of manufacture department stay the same each month, it’s not depend on the number of product. But indirect cost can be variable cost also. The cost of electricity for administration of manufacture department is variable cost monthly depending on the number of electricity use more or less.
Controllable cost and uncontrollable cost
Most of variable costs are controllable. To illustrate: low level manager in manufacture product is the direct monitoring and control of production process. They can be managing the raw material use to create product and direct labors that mean control the number of employees needed to complete product. Management can organize the use of resources effectively in the short term. On the other hand, many of fixed costs are uncontrollable. They are imposed in terms of management such as business can not decide the rental fees of factory, the rent for his unit negotiated by higher management, or the rates dictated by the local authority.
1. Participative budgeting
Budget preparation is the process by which organizational goals are translated into a plan that specifies the allocated resources, the selected processes, and the desired schedule for achieving these goals. There are two main types of budgeting: bottom-up budgeting and top-down budgeting. Participative budgeting is a method of preparing budgets in which managers prepare their own budgets. These budgets are then reviewed by the manager’s supervisor, and any issues are resolved by mutual agreement.
Vice President Sales
Vice President Finance
President and CEO
Vice President Production
All level of an organization should work together to create the budget. Each level in organization should contribute in the way that it best can in a cooperative effort to develop budget.
Lower level management is responsible for setting the estimate of budget data in a participative system and submits them to the next higher level of management. Before the budget is accepted, they must be reviewed and evaluated by middle management before they are transferred to the organization.
Advantage of participative budgeting
Participative budgeting is relevant to all member of particular project, it helps to encourage all participants contribute idea to built a project effectively.
Budget information is given clearly and fairly accurate because it use of the data available at the project management level
Working motivation is higher when an individual directly involved in setting goals rather than goals imposed from above. Self-imposed budget made commitments to implement the goals.
If the budget has been setting from top management, managers can say that budget is unreasonable or impractical to start, could not be performed. With participative budget, it does not happen when the managers set a budget for themselves.
Disadvantage of participative budget
Time consuming and costly because too many participants involved in setting budget project.
The influence of top manager is limited over the budget process. However, when the lower-level managers plan the short budgets and mid-range budgets, outlining organizational policies and goals, they can influence the outcome by issuing a statement.
Individual tend to overstate the real resource needs because they think that all budget will be cut in certain proportion by top manager and set a goal lower than actual for easy to achieve the goal.
2. Budget variance
a. Definition of budget variance:
Total budget variance is simply the difference between the actual cost of the input and its planned cost.
Total variance = Price variance + Usage variance
In standard costing systems, the total variance is broken down into price and usage variance.
Price variance is the difference between the actual and standard unit price of an input multiplied by the number of unit used.
Usage variance is the difference between the actual and standard quantity of inputs multiplied by the standard unit price of the input.
Total variance = (AP x AQ) – (SP x SQ)
(AQ x AP)
(SQ x SP)
(SQ x SP)
(AQ x AP)
(ACTUAL < STANDARD)
(ACTUAL > STANDARD)
AQ means the actual quantity of input used to produce the output
AP means the actual price of the input used to produce the output
SQ means the standard quantity
SP means the standard price
Favorable variance and unfavorable variance are not equivalent to good and bad variance. The terms indicate the relationship of the actual price or quantities to the standards prices and quantities.
b. Budget variance investigation
Manager’s responsibility is carefully calculated the variance because that is a part of effective control of organization. In general, it is difficult to manage external sources of budget variance (government policy, stock market, fluctuation of exchange rateâ€¦) rather than internal sources (raw material, cost per hour on direct labor…). Management should know about the acceptable range of performance.
If the budget has a favorable balance that means it has brought the profit to the company. Conducting an investigation to find out the reason why the variance of budget was favorable and it could be made more than in the future.
If the variance is small, it should not be too worried. In fact, a little variance between actual budget and the projected figures is always happens. With the very small difference, the manager can ignore them, no need to adopt strong action because it does not bring terrible consequences for the business. So, with little difference, the best way to solve is simply putting it into stride.
If the budget has unfavorable variance, head of department need to conduct an investigation to find out the main causes by external influence or internal influence. For example the increase of raw material usage per unit more than allowed standard because it was poor condition of machine or poor manufacturing. Find the cause and how to fix the problem; it is a good measure to prevent a similar situation may occur in the future. After having adverse variance the budget needs to rewrite or the budget needs to verify by internal audit.
Explain the term used in the statement
1. Committed fixed costs
Committed fixed costs relate to the investment in facilities, equipment, and basic organizational structure. The two characteristics of committed fixed costs are that they are long term in natural, and they cannot be significantly reduced event for short periods of time without seriously impairing the profitably or long- run goals of the organization. Even if operations are interrupted or cut back, the committed fixed cost will still continue largely unchanged (Garrison etal., 2006, P190). For example: Vietnam airlines has total 80 aircraft, the company must pay money for depreciation, maintenance and insurance expense. The expense is not depend on the number of times the plane fly or the number of passenger in plane. It is a committed fixed cost.
Decisions to acquire major equipment or to take on other committed fixed costs involve a long planning horizon. Management should make such commitments only after carefully analysis of the available alternatives. Once a decision is made to acquire committed resources, the company may be locked in to the decision for many years to come (Garrison etal., 2006, P191). For example the total committed fixed cost of renting the building for the hotel is very high and the company must commit to pay for it at least 5 years in Vietnam.
Uneven revenue flows
It is showed that the difference of demand (low or high) for product or service in different periods. At times the company is very busy and at others it suffers from very slack periods. The hospitality industry is often divided into two distinct seasons: high season and low season. The period time between two seasons can move and change each year. In high season, the hotel does not have enough room for customer and the room rate is very high that bring large of profit for the hotel. In contrast, in low season the hotel must reduce the price and apply promotion to attract tourist. It is a common situation of hotel and resort.
The implication of the above situation for the company
“Many of our cost are committed fixed cost. Our revenue flows occur very unevenly. To be profitable we have to take a flexible approach to pricing”
The company in hospitality industry has large proportion of fixed cost for the initial investment so the break even point is also very high. Company will operate with high level of capacity before earning a profit. But when passed break even point the profit will increase rapidly.
Committed fixed cost has a little effect to the level of costs in the short term. Revenue is the money the company receives for selling their product or service. It is calculated by taking the selling price and multiplying it by the number of units sold. Profit is the amount of money left over after costs have been covered. It is calculated by: total revenue minus total costs. Therefore, profits will not be improved by a greater emphasis on cost management of costs. The company will get profit if the revenue is maintained consistently above break even level. Due to the nature of leisure industry, the product is not in storage so the focus on revenue during the period low level of demand is the necessary task of this company.
By adopting a flexible approach the company is adapting the price of the product or service to suit the situation of the company and the amount of money customers are willing to pay. But the given price must be greater than variable cost and above break event point. This pricing strategy is designed to attract as much business as possible when the company has spare capacity. The price will be increased for busy periods when the company can expect to operate near to full capacity.
For example: In Vietnam, Da Nang has a long beautiful coastline. Seaside hotels have a high level of demand in the summer (from May to August), this time mainly to serve domestic tourist. The room rates are usually higher two times as much as normal. The hotels have maximum revenue in this period. In the low season from October to February next year, the hotel has launched promotions to attract tourist such as discount 30% room rate at Furama Resort or stay 2 night get 1 night free at Golden Sand Resort. In this case, at times of low volume an inflexible, cost orientated approach to pricing.
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