Describe the differences in behavior of fixed costs, variable costs, semi-variable costs and step costs. Then discuss how break-even analysis and contribution margin can be useful in making business decisions.
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In describing the differences in behavior of fixed costs, variable costs, semi-variable costs and step cost, it is imperative to understand what each are and how they affect expense to an organization.
A fixed cost is an expense to a business that does not change by either an increase or decrease in business activity. Some examples of fixed cost are rent or business insurance. These expenses remain constant regardless of business volume. A variable cost on the other hand, increases or decreases based on business activity or volume.
Some examples of variable costs are ingredients in a product made. If one has a company that makes plastic cups, then variable expense of plastic or ingredients to make plastic cups increase with volume or business activity. Conversely, the variable expense to produce the product line decreases with less volume or business activity.
The sum of fixed costs and variable costs is total costs. The key takeaway here is more production increases variable cost but fixed costs remain constant; but with increased volume in relation to unit cost reduces the fixed cost per unit. For example if fixed costs for an organization is $10,000, when more products are produced the per unit cost reduces the fixed unit cost per unit. This(increased volume) is a good thing.
According to reading of bookkeeping express, “Semi-variable costs consist of both fixed and variable costs. Part of the cost stays consistent (often a base cost) and part fluctuates with business activity. Examples include commission payments and overage charges Step costs are unique as they are a fixed cost that fall within certain threshold based on increased volume or decreased volume. This is an investment decision based on either taking on or not taking on new customers based on increasing expenses. This fixed cost can actually change.”
The contribution margin is the sales prices of a product minus the variable cost to produce that product. If we them input this calculation over the units sales price, we get the contribution margin ratio.
The break- even analysis determines at which point a company will be profitable by basing what is the minimum of product or services sold to return costs invested. This analysis includes variable costs and fixed costs and at which volume of sales equals the total of these costs to a sum of 0 or break-even.
The movement of these costs and their relative movement to increase or decrease in business activity is termed behavior of costs. Contribution margin and break-even analysis can give an organization a “snapshot” of where they need to be prior to reaching a level of profitability. This is a crucial metric in business decisions for an organization.
Accounting: Text and Cases, 13thEdition, by Anthony, Hawkins & Merchant. New York: Irwin/McGraw-Hill, Inc., 2011.
N.A, (Jan 2016), Understanding Fixed, Variable and Semi-Variable Cost retrieved from:
Fixed cost are cost that do not change so long as the production is within relevant range. For instance a fixed cost of 3000 with a production of 100 produces a fixed cost per unit will be 30. If the production increases the fixed cost per unit will decrease. Additionally, the fixed cost is something that will incur no matter if no production happens.
Variable cost on the other hand changes in direct proportion to production output. Therefore, the more production unit increases the more variable cost increases and vice versa. For example, in labor terms, if a typical worker takes 30 minutes in manufacturing a unit and the hourly wage rate is $20, total labor cost will be $10 per 1 unit, $20 for 2 units, $30 for 3 units and so on.
Semi- variable costs are costs that have both fixed and variable components. The fixed element does not change with the change in activity level, however, the variable element changes in proportion to the activity level. For example, companies typically pay fixed base salaries and variable bonuses and commissions depending on employee performance.
Step costs is a cost that does not change steadily when the activity in production changes. A step cost operates almost like a fixed cost, however it does have certain boundaries, outside of which can cause changes to the cost. For example, a facility cost will remain steady until additional floor space is constructed, at which point the cost will increase to a new and higher level as the entity incurs new costs to maintain the additional floor space, to heat and air condition it, insure it, and so forth.
Then discuss how break-even analysis and contribution margin can be useful in making business decisions.
The break-even point identifies where the business starts operating without taking a loss or earning a profit. It simply the total amount of sales the business needs before profits can be earned. The breakeven analysis helps the company identify excessive fixed costs (or other cost in general), here is where a company can better control or reduce certain cost, so that profitability is achieved quicker and with less sales. The formula for the breakeven analysis goes as followed:
Fixed Costs ÷ (Sales price per unit – Variable costs per unit)
Accounting: Text and Cases, 13th Edition, by Anthony, Hawkins & Merchant. New York: Irwin/McGraw-Hill, Inc., 2011.
Bragg, Steven. “Step Costs Definition.” AccountingTools, AccountingTools, 20 Apr. 2020, www.accountingtools.com/articles/what-is-a-step-cost.html.