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Fixed costs are expenses that remain the same and do not vary with production or sales levels. Examples include rent, property, converting fixed costs to variable costs, taxes, insurance, and advertising, all which remain constant regardless of the activity. Variable costs are expenses that change in proportion with activity or volumes, or which directly depend on the volume of sales or production. For instance, the cost of raw material depends on the production volume, and higher the raw materials procured, the better the economies of scale leading to reduced handling costs, and vice versa.
Variable costs remain the same per unit of production. Traditional managerial accounting divides fixed costs equally to the number of units manufactured or sold, or considers it separately to determine overall profit or loss. In this scenario, the higher the volume, the lower the fixed cost appropriation per unit, and lower the volume, the higher the fixed cost appropriation per unit of production.
In a strict sense, all costs vary over time and no cost is a purely fixed cost. For instance, lower production volumes would mean underutilization of the factory and ultimate shifting to smaller premises, and thereby, lesser rent. Production of more units would mean more investment and stakes, and hence higher insurance premiums, and the like. The concept of fixed costs is, therefore, relevant only in the short term, usually for the specific accounting period.
Image Credit: Wikimedia Commons
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Ways By Which Companies Convert Fixed Costs to Variable Cost
The ways of directly converting fixed costs to variable costs are many. Some such ways include:
- Increasing variable pay such as production incentives and sales commission and decreasing basic fixed pay.
- Converting infrastructure to a pay-per-use basis, such as contract manufacturing.
- Outsourcing administration jobs on a percentage or per-work basis, and more.
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Activity Based Costing
The managerial accounting methodology of converting fixed costs to variable costs is activity based costing. Activity based costing uses the principle of assigning the cost of each organizational activity to products and services according to the actual consumption of the activity resource by such product or service.
In traditional accounting, the rent for a factory, energy charges, and wages of workers, excluding variable pay, remains part of fixed costs. Activity based costing converts these costs into variable costs, assigning such costs to the products or services manufactured per usage.
If a factory with a daily rent of $120 and a manufacturing capacity of 180 units operates at 100 percent capacity, traditional managerial accounting system divides the rent of $120 with the total number of units produced; 180, to assign a per unit fixed cost of $.067.
Activity based costing determines the extent of usage by each product per day. For instance if Product A utilizes the factory for 20 hours to manufacture 100 units and Product B utilizes the factory for only 4 hours to manufacture 80 units, activity based costing converts the $120 fixed cost into variable cost as follows:
- $120 divided by total units of time available = 120/24 = per hour rent of $5
- $5 x 20 hours consumed by Product A = $100
- $100 divided by 100 units of Product A produced during this time = variable cost of product A = $1.00
- Per hour rent of $5 x 4 hours consumed by Product B = $20
- $20 divided by 80 units of Product B produced during this time = Variable Cost of Product B = $0.25
Converting fixed costs to variable costs helps in identifying non-remunerative activities and allocation of more resources to activities with maximum potential. This makes the difference between success and failure.
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- Reiss, Bob. "Oursourcing Turns Fixed Costs Into Variable Costs." Retrieved from http://www.entrepreneur.com/article/217487%20on%2004%20Novemebr%202010
- Michael C. O'Guin. (1991.) "The complete guide to activity-based costing." Prentice Hall. ISBN: 0138533180, 9780138533182