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Introduction lớn Fixed and Variable Costs

Cost is something that can be classified in several ways, depending on its nature. One of the most popular methods is classification according to fixed costs và variable costs. Fixed costs bởi vì not change with increases/decreases in units of production volume, while variable costs fluctuate with the volume of units of production. Fixed và variable costs are key terms in managerial accounting, used in various forms of analysis of financial statementsAnalysis of Financial StatementsHow lớn perkhung Analysis of Financial Statements. This guide will teach you lớn perkhung financial statement analysis of the income statement,.

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The first illustration below shows an example of variable costs, where costs increase directly with the number of units produced.

In the second illustration, costs are fixed & bởi not change with the number of units produced.

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Graphically, we can see that fixed costs are not related lớn the volume of automobiles produced by the company. No matter how high or low sales are, fixed costs remain the same.

On the other hand, variable costs show a linear relationship between the volume produced & total variable costs.

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Financial Accounting vs. Managerial Accounting

While financial accounting is used to lớn prepare financial statements that benefit external users, managerial accounting is used khổng lồ provide useful information to lớn people within an organization, mainly management, to lớn help them make more informed business decisions.

A clear comparison can be seen in the following table:

Financial AccountingManagerial Accounting
Purpose of informationTo communicate the company’s financial position khổng lồ external users (i.e. investors, banks, regulators, government)To help management make better decisions lớn fulfill the company’s overall strategic goals
Primary usersExternal usersInternal (management)
Focus and emphasisPast orientedFuture oriented
Time spanAnnual or quarterly financial reports depending on companyVaries from hourly to lớn years of information

Variable Costs vs. Fixed Costs

The table below summarizes the key difference between fixed and variable costs:

Variable CostFixed Cost
DefinitionCosts that vary/change depending on the company’s production volumeCosts that bởi not change in relation to lớn production volume
When Production IncreasesTotal variable costs increaseTotal fixed cost stays the same
When Production DecreasesTotal variable costs decrease Total fixed cost stays the same
ExamplesDirect Materials (i.e. kilograms of wood, tons of cement)Rent
Direct Labor (i.e. labor hours)Advertising
Insurance
Depreciation

Example 1 – Fixed vs. Variable Costs

The following table shows various costs incurred by a manufacturing company:

CostVariableFixed
Depreciation of executive jetx
Cost of shipping finished goods to lớn customersx
Wood used in manufacturing furniturex
Sales manager’s salaryx
Electricity used in manufacturing furniturex
Packing supplies for shipping productsx
Sand used in manufacturing concretex
Supervisor’s salaryx
Advertising costsx
Executive’s life insurancex

Example 2

Let’s say that XYZ Company manufactures automobiles and it costs the company $250 khổng lồ make one steering wheel. In order khổng lồ run its business, the company incurs $550,000 in rental fees for its factory space.

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Let’s take a closer look at the company’s costs depending on its cấp độ of production.

Number of Automobiles ProducedVariable Cost per Steering WheelTotal Variable CostTotal Fixed Cost
1$250$250$550,000
500$250$125,000$550,000
1000$250$250,000$550,000
1500$250$375,000$550,000

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Applications of Variable và Fixed Costs

Classifying costs as either variable or fixed is important for companies because by doing so, companies can assemble a financial statement called the Statement/Schedule of Cost of Goods Manufactured (COGM)Cost of Goods Manufactured (COGM)Cost of Goods Manufactured (COGM) is a term used in managerial accounting that refers to lớn a schedule or statement that shows the total. This is a schedule that is used khổng lồ calculate the cost of producing the company’s products for a set period of time.

The COGM is then transferred to lớn the finished goods inventory tài khoản & used in calculating the Cost of Goods Sold (COGS)AccountingOur Accounting guides and resources are self-study guides to learn accounting và finance at your own pace. Browse hundreds of guides & resources. on the income statement.

By analyzing variable and fixed cost prices, companies can make better decisions on whether lớn invest in Property, Plant, và Equipment (PPE)PP&E (Property, Plant & Equipment)PP&E (Property, Plant, & Equipment) is one of the core non-current assets found on the balance sheet. PP&E is impacted by Capex,. For example, if a company incurs high direct labor costs in manufacturing their products, they may look to invest in machinery, which will reduce these high variable costs in exchange for more stable & known fixed costs.

This decision should be made with volume capacity and volatility in mind as trade-offs occur at different levels of production. High volumes with low volatility favor machine investment, while low volumes & high volatility favor the use of variable labor costs.

If sales were low, even though unit labor costs remain high, it would be wiser not khổng lồ invest in machinery và incur high fixed costs because the high unit labor costs would still be lower than the machinery’s overall fixed cost.

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The volume of sales at which the fixed costs or variable costs incurred would be equal to lớn each other is called the indifference point. Finally, variable and fixed costs are also key ingredients to lớn various costing methods employed by companies, including job order costing, process costing, và activity-based costing.

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