Fixed and variable costs - how to identify?

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Each enterprise incurs a number of costs related to its business activity. There are fixed and variable costs. This division has a significant impact on the decisions made in the company, both in the short and long term. The separation of fixed and variable costs can be carried out on the basis of several methods, which we will introduce in this article.

Fixed and variable costs

Fixed costs are borne by the enterprise, irrespective of the production volume or the scope of activity of a given unit. This means that the amount of fixed costs incurred does not depend on the volume of production or the size of the activity, what is more, the company incurs them also in periods when nothing is sold. These include, among others: employee salaries, rent, leasing and utility costs. Fixed costs can change, but these changes tend to be long-term and not driven by the scale of your business.

The amount of variable costs, in contrast to the fixed costs of the enterprise, depends on the size of the activity performed. Variable costs are costs incurred in the consumption of raw materials and energy.

Methods of extracting fixed and variable costs

Despite the established definitions of fixed and variable costs, in practice it is often difficult to unambiguously assign a specific cost to a given definition. In order to establish the breakdown between fixed and variable costs, specific methods are used to facilitate proper qualification. In practice, many different methods of cost allocation are used, but the most commonly used are the accounting, engineering and statistical methods.

Accounting method

The accounting method is based on the division of individual cost items into fixed and variable costs, respectively. Based on the assessment of the splitter, these costs are posted to the appropriate accounts. This method is highly subjective due to the fact that it is based primarily on the experience and knowledge of the accountant. In practice, however, it is very simple, as it does not require any additional calculations.

Engineering method

The engineering method is similar to the accounting method, as it also involves a subjective assessment of the division of costs into constants and variables. This, however, is characterized by much greater accuracy, as it requires the assessment of the method of consumption of production factors with the use of detailed product analysis, as well as the technological process.

Statistical method

On the other hand, statistical methods differ from those previously described and often require complex mathematical calculations. They are based on the concept that the total operating costs of a company are linearly dependent on the scale of the company's operations. They are based on historical data, on the basis of which it is possible to make appropriate calculations, when we determine the structure of fixed and variable costs. Among the statistical methods, several can be distinguished, but the simplest are: the visual (graphical) method and the two-point method.

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Visual method

The division of costs into fixed variables based on the visual method is performed by graphically delineating the cost line that defines the level of fixed costs. On the coordinate system, where the Y axis (vertical) is the production costs, and the X axis - the production volume, the points corresponding to the ratio of the production volume to the costs incurred are plotted, and based on visual analysis, a trend is determined by drawing a straight line adjusted to those on the point plane.

Two-point method

Using the two-point method, the extreme points, i.e. those representing the highest and the lowest level of costs in the period under consideration, should be determined from the time series of costs and production. Based on these quantities, the marginal cost is calculated. The marginal cost is the increment of total costs between the lowest and highest cost levels in the period considered per additional unit of production. When we know the marginal cost, we estimate the level of fixed costs, which is the difference between the total cost and the cost of a given production. The amount of total costs is determined based on the formula:

total costs = (jkz × X) + ks

where:
jkz - unit variable costs,
X - production volume,
ks - fixed costs.

Example. 1

In the fourth quarter of 2019, the production company achieved the following costs.

Month Production volume (pcs.) Production costs (PLN)
October 2850 2500
November 2300 22500
December 2530 23600

First, the lowest and highest total costs in a given period for a given production volume should be determined, where:

  • the highest total costs are PLN 25,000 for the production of 2,850 items,
  • the lowest total costs are PLN 22,500 for the production of 2,300 pcs.

Then determine the difference between marginal production and production costs, where:

  • the difference in total costs is PLN 2,500,
  • production volume difference: 550 pieces.

On this basis, you can calculate the unit variable cost:

jkz = 2500/550 = 4.55

Having all of the above information, you can find the value of your fixed costs for January:

25,000 = (4.55 × 2,850) + Fr.

ks = 25,000 - 12,967.50

ks = PLN 12,032.50

The fixed costs amount to PLN 12,032.50

Determining the amount of fixed costs in relation to the company's variable costs is important due to the obligation to properly classify them, and also affects the decisions made in the company, especially in the short-term perspective. It is an important tool for large enterprises, especially production ones, where the level of costs incurred is particularly monitored, and in companies that keep complete books of accounts for persons holding decision-making positions. However, the choice of the appropriate method of cost extraction remains an individual matter and depends on the subjective assessment of the situation of a given enterprise.