Once you understand the difference between fixed and variable costs, classify each of your business’s costs. Many costs, such as the examples mentioned above, will be easy to classify. Others may be more ambiguous. Some costs can be difficult to classify, not behaving in a strict fixed or variable pattern. For example, an employee may be paid a fixed salary in addition to a commission that varies with sales volume. These costs are best broken up into separate fixed and variable elements. In this case, only the employee’s commission would be treated as a variable cost. [4] X Research source
Imagine the costs incurred for the most recent year are as follows: $35,000 of raw materials, $20,000 of packaging and shipping, and $100,000 in employee wages. The total variable costs for the year are therefore 35,000+20,000+100,000{\displaystyle 35,000+20,000+100,000}, or $155,000{\displaystyle $155,000}. These costs are directly related to the production volume for that year.
The unit variable cost is simply the variable cost per unit produced. It is the extra cost incurred by producing each additional unit. For example, if the business above produced 100 more units, it would expect to incur additional production costs of $31. [5] X Research source
An example of a mixed costs is the wage expense for an employee that earns salary plus commissions. The salary is paid even if no sales are made, but commission depends on the sales volume. In this example, the commission is a variable cost and salary is fixed. [6] X Research source Mixed costs can also apply to wage earners if they are guaranteed a fixed number of hours each pay period. Regular hours would be a fixed cost, but any overtime would be variable. In addition, the cost of employee benefits might be recognized as a mixed cost. A somewhat more complicated example is that of utilities costs. Electricity, water, and gas must be paid even if no production occurs. However, they may be used in greater amounts as part of production. Splitting these costs into fixed and variable categories requires a more complex method.
For example, imagine that your company cuts metal parts with a water cutter as part of a production process. This requires water as a variable cost that increases with the amount of production. However, you also use have a water expense that arises from running your production facility (for drinking, restrooms, etc. ). Your water costs would then be a mixed cost. Say that in this example, in the highest month you had a water bill of $9,000 and 60,000 machine-hours of production. In the lowest, you had an $8,000 water bill and 50,000 machine-hours of production.
In this example, this would be VCR=$9,000−$8,00060,000−50,000{\displaystyle VCR={\frac {$9,000-$8,000}{60,000-50,000}}}. This then simplifies to VCR=$1,00010,000{\displaystyle VCR={\frac {$1,000}{10,000}}}, which gives $0. 10{\displaystyle $0. 10}. This means that each additional machine-hour of production costs $0. 10. [8] X Research source
To determine whether or not variable costs are staying constant, divide total variable cost by revenue. This will give you an idea of how much of costs are variable costs. You can then compare this figure to historical variable cost data to track variable cost per units increases or decreases. For example, if total variable costs were $70,000 one year and $80,000 the next while revenues were $1,000,000 and $1,150,000, respectively, you could see that variable costs remained fairly stable through those two years at $70,000÷$1,000,000{\displaystyle $70,000\div $1,000,000}, or 7{\displaystyle 7} percent, and $80,000÷$1,150,000{\displaystyle $80,000\div $1,150,000}, or 6. 96{\displaystyle 6. 96} percent of revenue, respectively).
If a company primarily experiences variable costs in production, they may have a more stable cost per unit. This will lead to a steadier stream of profit, assuming steady sales. This is true of large retailers like Walmart and Costco. Their fixed costs are relatively low compared to their variable costs, which account for a large proportion of the cost associated with each sale. [10] X Research source However, a company with a higher proportion of fixed costs would more easily be able to take advantage of economies of scale (greater production leading to lower per-unit costs). This is because revenues would increase much faster than expenses. For example, a computer software company would have fixed costs associated with product development and support staff, but would be able to scale up software sales without incurring significant variable cost increases. That said, during slumping sales, a company that relied primarily on variable costs would be more easily able to scale back production and remain profitable, while a company with primarily fixed costs would have to find a way to deal with much higher per-unit fixed costs. [11] X Research source A company with high fixed costs and low variable cost also has production leverage, which magnifies profits or loss depending upon revenue. Essentially, sales above a certain point are much more profitable, while sales below that point are much more expensive. Ideally, the company should strive to strike a balance between risk and profitability by adjusting their fixed and variable costs.
A higher than average per-unit cost suggests that a company uses a larger amount of or spends more on resources (labor, materials, utilities) to produce goods than their competitors do. This can represent low efficiency or expensive resources. In either case, the company will not be as profitable as its competitors unless it makes some change in its budget. [12] X Expert Source Madison BoehmBusiness Advisor, Jaxson Maximus Expert Interview. 29 September 2021. It should reduce its expenses or raise its prices. On the other hand, a company that is able to produce the same goods at a lower cost realizes a competitive advantage by being able to undercut the rest of the market on price. This cost advantage could be due to cheaper resources, cheaper labor, or greater manufacturing efficiency. For example, a company that is able to get cotton at a lower price than their competitors could produce shirts at a lower variable cost and thus charge a lower price for them. Publicly traded companies provide their financial statements publicly either through their websites or the Securities and Exchange Commission (SEC). Variable cost information can be figured out by studying their income statements.
For example, if your company is planning to produce a new product that requires an initial investment of $100,000, you would want to know how many of that product you would need to sell to regain your investment and earn a profit. Doing so would require adding the investment and other fixed costs together with variable costs and subtracting them from revenue at various production levels. You can calculate a break even point using the following formula: Q=FP−v{\displaystyle Q={\frac {F}{P-v}}}. In the formula, F and v are your fixed and per-unit variable costs, respectively, P is the selling price of the product, and Q is the break-even quantity. [14] X Research source For example, if other fixed costs over the course of production total $50,000 (in addition to the original $100,000 for a total of $150,000 in fixed costs), variable costs are $1 per unit, and the product sells for $4 per unit, you would calculate a break point by solving Q=$150,000$4−$1{\displaystyle Q={\frac {$150,000}{$4-$1}}}, which yields a result of 50,000 units.
