Last week I discussed how easy it is to get into trouble by ignoring the nature of cost. Whether you are a manufacturer, distributor of goods or a service company, understanding how costs affect your company is crucial to profitability. Using the wrong type of cost calculation for your business can make or break your company. Last week we looked at Variable Costs. This week we continue with Fixed and Semi-Variable Costs.
In contrast to variable costs, fixed costs remain the same despite increases or decreases in business activity. For example, a manufacturing plant that must use oil to heat during the winter must heat the plant whether production increases or decreases. The grocery retailer that rents their building must pay the rent no matter how many bottles of milk are sold, and the service company must pay the rent for their offices, whether billable hours increase or decrease.
Fixed costs have characteristics that are different from variable costs. For example, while the cost of heating cannot be directly related to the nails produced at the factory, the cost of heating must be included in the nail’s cost. Therefore, fixed costs will actually react in the opposite way to variable costs; if the plant produced 100,000 nails this month and heating cost was $2000, then each nail would have to include $.02 cost of heating.
While the fixed cost does not rise or fall in response to the activity, in this case manufacturing nails, the effect on the cost of producing the nails does respond to the level of activity. Should production of the nails decline by 50%, then the cost of heating on each nail would rise to $.04. In addition, fixed costs may or may not be controllable. It is up to management to decide whether or not to use those resources and incur the cost. If incurred, the cost would be fixed.
Committed fixed costs cannot be controlled. The example of heat in the plant manufacturing nails would be non-discretionary. A service company may sub-contract consultants for a fixed fee per month, but a cancellation clause in the contract would be an example of non-committed or discretionary fixed cost.
In order to define Semi-variable cost, let’s take new product development as an example, say the development of a new widget. There are three components to cost: labor, materials, and machinery (we will ignore overhead for the moment). The materials and machinery will be used to create prototypes, and the cost of each prototype is $2,000. It seems like we have all the information to move ahead.
However, a closer look at how the costs behave may reveal useful information. The machinery cost actually contains two components: a setup cost of $1000 and an hourly usage rate of $250. The budget assumes that each prototype will take 4 hours to create. Every time that the machine is set up to produce a prototype, there is a charge of $1000. Assuming that it takes 4 hours to produce a prototype, the cost of using the machine is also $1000. This is an example of a semi-variable cost; part of the cost is fixed (the setup) and part of the cost is variable (producing the prototype), depending on the time the machine is used.
Knowing that there is a semi-variable cost can be useful in doing a risk analysis. For example, supposing there were problems in creating several of the prototypes that made it necessary to produce 7 prototypes instead of 5; what would the total cost of prototypes then be? 21,000? $15,000?
If, for example, the first prototype was spoiled after only an hour, it would have cost $2,250, instead of $3000, as three hours of machine time were not used. On the other hand, there would be an additional $1,000 set up cost in order to replace the first prototype. Knowledge of how this cost “behaves” would certainly help in risk analysis and budgeting.
As we saw in the illustration, semi-variable costs contain both fixed and variable elements. The real key is in being able to identify the fixed and variable elements of semi-variable costs. In the new product development example, the budget predicts that the overall cost of producing a prototype is $2,000. However, we discovered on the three major components of cost for developing the widget, materials, direct labor and machine costs, the actual cost could vary quite a bit.
On closer observation, we realized that the machine cost had two elements as well, set up costs that did not change from one prototype to the next and machine hours that could. The driver of the fixed portion of the cost is that machine setup costs the same regardless of how many hours it took to create the prototype.
Knowing how each element of the semi-variable cost functions will give us a clear picture of overall cost. Next week we will look at some examples of how the wrong cost model can cost you. This column is based on material from my book, Project Management Accounting, published by John Wiley & Sons.