Introduction to Managerial Accounting

Cost Behavior

Variable and Fixed Costs

There are two types of cost: variable costs and fixed costs.

Costs are generally classified as either fixed or variable in the context of a company's activity level. Fixed costs do not change for a given period, despite any changes that the company might experience in terms of its activity level. Fixed costs play an important role in business. For instance, fixed costs allow companies to conduct business and are not merely a consequence of the manufacturing process. As such, fixed costs are usually measured by time.

Examples of fixed costs include rent and property taxes. Rent is typically paid on a monthly basis, and taxes can be paid annually or quarterly. Because fixed costs are set, the amount allocated per unit varies based on production level. For example, when a company produces more units, the fixed costs are spread across more units, which means the fixed cost per unit is lower. In contrast, when a company produces fewer units, the fixed costs are spread across fewer units, and the fixed cost per unit is higher. However, the total fixed cost amount does not change.

Total Fixed Costs and Fixed Costs per Unit

Fixed costs as a total amount remain the same for a given period, but the amount of fixed costs allocated to each unit varies based on volume.
Variable costs differ from fixed costs in that they fluctuate for a given period because they are directly related to volume. For example, if a company produces more manufactured items in a three-month period, then its costs for raw materials are likely to increase. Overtime costs may rise too. There may even be changes to utilities if the company decides to add a night shift. The most common variable costs are direct labor and direct material—in other words, the wages for the people making the items and the costs of the raw materials they use.

Any change in a company's volume creates a need for more or less direct material and direct labor. Unlike fixed costs, variable costs are measured by units or volume, not by time. Also, though total variable costs fluctuate based on a company's volume, the variable cost per unit remains the same, and it is the total amount of variable cost that varies based on the company's activity level.

Mixed Costs Calculations

Variable costs and fixed costs can be combined to provide a mixed cost amount.

Managerial accountants often combine variable costs and fixed costs to provide a mixed cost amount. Mixed costs, also known as semivariable costs, are expenses that are a combination of fixed costs and semivariable costs that both fluctuate and remain the same with volume changes.

One of the most common examples of a mixed cost is a salesperson who makes a base salary plus commission. If the salesperson has a bad month and makes no sales, then the company must pay only their base salary. However, if she has a terrific month and makes twice as many sales as last month, then the company must pay their base salary plus a significant commission.

Although mixed costs might naturally occur in a company's costs, analyzing expenses in this form is not always useful. Therefore, mixed costs are usually categorized as only variable or only fixed in order to more accurately predict a company's costs for a given period. This is due to the nature of variable costs and how they are difficult to predict as they fluctuate with volume.

For example, consider renting a tool from a local hardware store. The tool costs $300 per week plus $10 per hour of use that is recorded on the tool. The rental charge of $300 per week is a fixed cost because it does not change with how frequently the tool is used. The $10-per-hour charge is a variable cost because it fluctuates based on how many hours the tool is used.
A company's mixed costs consist of both variable costs and fixed costs. The variable costs vary based on volume, and the fixed costs remain the same.
Another common example of a mixed cost is a cell phone bill. Typically, cell phone bills have two different costs: a flat rate for a particular service plan and an overage rate for any use that exceeds the service plan. The flat rate is the fixed cost because it does not change. The overage rate is the variable cost because it is based on the amount of overage that occurred.