Management Accounting

Cost Classification – Part 4

Costs correlated to activity levels

Fixed costs

All those costs are fixed costs which do not change with the change in the level of activity (within a certain range) i.e. if a business produces/ sells more or less products. Examples for fixed costs are

•Rent & business rates

•Fixed salaried staff

•Building Insurance

•Telephone line rental

•Standing charges on gas and electricity connections etc

Stepped fixed costs

We discussed above that fixed costs do not change within a certain range i.e. capacity limit. What happens when capacity of the factory is exceeded i.e. the business needs to produce more than 50,000units?

This question brings us to a well understood viewpoint that all costs are variable (semi-variable) in the long-term. Fixed costs are fixed within a given range and then it increases. However, increase in the fixed costs is not a gradual one but it usually jumps or takes a step up. For example. In example 2.3, when the same business needs to produce more than 50,000 units, the production facilities need expansion. At this stage, the management of the business need to evaluate by how much they need to expand their production facility. There could be two scenarios

1-The growth in business orders is limited and/or unsustainable

2-The business will keep growing in future

A logical solution to deal with option 1 would be to extend the existing factory. Let’s say that an extra line of 10,000 units is added to the current production capacity. There will be an increase in the fixed costs but not a proportionate one. Maintenance and depreciation of machinery will cost additional money and there may be a need to hire more personnel but there will be no increase in the rent & rates. Let’s say this additional capacity will cost £5,000 per year. This will make the cost to jump from £50,000 to £55,000 irrespective of how much of the additional 10,000 production capacity is utilised.

If option 2 (continuous growth) is more probable then it will be better to build a new factory altogether rather than extending the existing one. Let’s say a similar factory is built which will cost the same amount in fixed costs as the first one. In this case the fixed cost will jump from £50,000 to £100,000. Even if the business produces only 25,000 units in the second factory. This shows how fixed costs increase in steps unlike a variable cost as we will discuss next. The same increase occurs when other fixed costs need additions for example, hiring another supervisor on a fixed salary, opening another shop etc.

Variable cost

A variable cost is a cost which changes with the change in the level of activity and the change in cost is in the same proportion as the change in activity. This means an increase of 50% in the activity will increase the cost by 50% too. Cost per unit for variable cost will remain same at different activity levels (within a given range, obviously).

Semi-Variable/ Semi-fixed Cost

These are the costs which have an element of both fixed and variable cost to it. As a result, a part of these costs remains fixed when the activity changes while the other element changes as a variable cost would do. The total cost will change when the production/activity increases like a variable cost but the cost per unit will not be the same as it is the case with variable costs.

For example, most of the utilities in the UK have a fixed element of cost called standing charges which means a fixed amount will be payable even if the customer does not use the service at all. The cost of variable element depends on the usage, for example, KWH of electricity or Gigabits of data. For many businesses, labour cost is also semi-variable/fixed as they would employ permanent as well as per hour and zero hours contracted employees which are used when the production or other activities exceed a certain level.

From management viewpoint, the whole purpose of understanding costs is to enable them to control these costs, plan for the future and make better decisions. It is well understood that fixed costs cannot be managed in the short-medium term but variable costs can be reduced quickly if needed. However, semi-variable costs pose a challenge in their raw form as the impact of a decision cannot be evaluated on these costs with precision. Therefore, these costs are segregated into fixed and variable costs to know the exact amount of fixed and variable amount in a certain total for a cost e.g., total payroll cost or production costs.

This article is written by Raja Mizan who is a senior lecturer in accounting & finance in a UK university. He is an ACCA member and also runs his own accountancy practice RMR Accountants & Business Advisors.

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