Scott Hebert

Almost every business cost can be assigned to one of two categories: fixed or variable. Fixed costs are those that remain constant and are not affected by sales or production levels. Variable costs, on the other hand, remain constant per unit. These total variable costs increase as sales and production levels increase. As you can see, fixed and variable costs are opposites. As production levels change, fixed costs remain constant while variable costs increase. When looking at costs on a per unit basis, variable costs remain constant for all production levels while fixed costs become cheaper per unit as production increases (Toolkit Media Group, 2008).

It has been suggested that the company could benefit from converting fixed costs into variable costs. One problem with fixed costs is that they are more expensive per unit if the resource is under-utilized. For example, if a machine can produce 1,000 units but is only used to produce 500, then the per unit fixed cost for that production run is twice as much. Therefore, the desire to convert fixed costs into variable costs is based on the assumption that it will avoid the overhead costs associated with unused capacity. Fixed costs that can be converted into variable costs include machine rental fees based on usage rather than per machine costs or hourly employees rather than salaried employees (Atkinson, Kaplan, Matsumura, & Young, 2007).

Unfortunately, the decision to convert fixed costs into variable costs must be made on a case by case basis. If the per unit variable cost is less than or equal to the fixed per unit cost when the activity in question is operating at theoretical capacity, then it makes sense to convert from fixed costs to variable costs since no resource can operate at theoretical capacity. Instead, it is recommended to estimate the practical capacity of the resource as 80% to 85% of the theoretical capacity (Atkinson, et al., 2007). If per unit variable costs are higher than theoretical capacity per unit fixed costs, then the decision must be made based on anticipated resource usage. In other words, there is some lower usage level where per unit fixed costs meets the higher per unit variable cost. If usage is anticipated to be below this level, then it makes more sense to use fixed costs rather than variable costs.

Fixed costs vary from company to company. A manufacturer of antique replica furniture will have fixed costs related to production. These include factory and machine rental, salaried employees, and insurance. Many of these costs can be converted into variable costs. Even factory rental can be changed if the company rents part of a larger space. Unfortunately, the decision to convert these costs from fixed to variable requires frequent analysis to ensure the largest profit margin for the company.

References

Atkinson, A. A., Kaplan, R. S., Matsumura, E. M., & Young, S. M. (2007). Management accounting (5th ed.). Upper Saddle River, NJ: Pearson.

Toolkit Media Group. (2008). Fixed and variable costs. Retrieved December 8, 2008.

Tags: accounting, business