Fixed costs are costs that remain the same in total regardless of changes in the activity level. Examples include property taxes, insurance, rent, supervisory salaries, and depreciation on buildings and equipment. Because total fixed costs remain constant as activity changes, it follows that fixed costs per unit vary inversely with activity: As volume increases, unit cost declines, and vice versa.
To illustrate the behavior of fixed costs, assume that Damon Company leases its productive facilities at a cost of $10,000 per month. Total fixed costs of the facilities will remain constant at every level of activity, as part (a) of Illustration 18-2 shows. But, on a per unit basis, the cost of rent will decline as activity increases, as part (b) of Illustration 18-2 shows. At 2,000 units, the unit cost per tablet computer is $5 ($10,000÷2,000)$5 ($10,000÷2,000). When Damon produces 10,000 tablets, the unit cost of the rent is only $1 per tablet ($10,000÷10,000)($10,000÷10,000).
ILLUSTRATION 18-2 Behavior of total and unit fixed costs
The trend for many manufacturers is to have more fixed costs and fewer variable costs. This trend is the result of increased use of automation and less use of employee labor. As a result, depreciation and lease charges (fixed costs) increase, whereas direct labor costs (variable costs) decrease.
PEOPLE, PLANET, AND PROFIT INSIGHT
Gardens in the Sky
© Jani Bryson/iStockphoto
Because of population increases, the United Nations’ Food and Agriculture Organization estimates that food production will need to increase by 70% by 2050. Also, by 2050, roughly 70% of people will live in cities, which means more food needs to be hauled further to get it to the consumer. To address the lack of farmable land and reduce the cost of transporting produce, some companies, such as New York‐based BrightFarms, are building urban greenhouses.
This sounds great, but do the numbers work? Some variable costs would be reduced. For example, the use of pesticides, herbicides, fuel costs for shipping, and water would all drop. Soil erosion would be a non‐issue since plants would be grown hydroponically (in a solution of water and minerals), and land requirements would be reduced because of vertical structures. But, other costs would be higher. First, there is the cost of the building. Also, any multistory building would require artificial lighting for plants on lower floors.
Until these cost challenges can be overcome, it appears that these urban greenhouses may not break even. On the other hand, rooftop greenhouses on existing city structures already appear financially viable. For example, a 15,000 square‐foot rooftop greenhouse in Brooklyn already produces roughly 30 tons of vegetables per year for local residents.
Sources: “Vertical Farming: Does It Really Stack Up?” The Economist (December 9, 2010); and Jane Black, “BrightFarms Idea: Greenhouses That Cut Short the Path from Plant to Grocery Shelf,” The Washington Post (May 7, 2013).
What are some of the variable and fixed costs that are impacted by hydroponic farming? (Go to WileyPLUS for this answer and additional questions.)
In Illustration 18-1 part (a) (page 884), a straight line is drawn throughout the entire range of the activity index for total variable costs. In essence, the assumption is that the costs are linear. If a relationship is linear (that is, straight‐line), then changes in the activity index will result in a direct, proportional change in the variable cost. For example, if the activity level doubles, the cost doubles.
It is now necessary to ask: Is the straight‐line relationship realistic? In most business situations, a straight‐line relationship does not exist for variable costs throughout the entire range of possible activity. At abnormally low levels of activity, it may be impossible to be cost‐efficient. Small‐scale operations may not allow the company to obtain quantity discounts for raw materials or to use specialized labor. In contrast, at abnormally high levels of activity, labor costs may increase sharply because of overtime pay. Also, at high activity levels, materials costs may jump significantly because of excess spoilage caused by worker fatigue.
As a result, in the real world, the relationship between the behavior of a variable cost and changes in the activity level is often curvilinear, as shown in part (a) of Illustration 18-3. In the curved sections of the line, a change in the activity index will not result in a direct, proportional change in the variable cost. That is, a doubling of the activity index will not result in an exact doubling of the variable cost. The variable cost may more than double, or it may be less than double.
ILLUSTRATION 18-3 Nonlinear behavior of variable and fixed costs
Total fixed costs also do not have a straight‐line relationship over the entire range of activity. Some fixed costs will not change. But it is possible for management to change other fixed costs. For example, in some instances, salaried employees (fixed) are replaced with freelance workers (variable). Illustration 18-3, part (b), shows an example of the behavior of total fixed costs through all potential levels of activity.
▼ HELPFUL HINT
Fixed costs that may be changeable include research, such as new product development, and management training programs.
For most companies, operating at almost zero or at 100% capacity is the exception rather than the rule. Instead, companies often operate over a somewhat narrower range, such as 40–80% of capacity. The range over which a company expects to operate during a year is called the relevant range of the activity index. Within the relevant range, as both diagrams in Illustration 18-4 show, a straight‐line relationship generally exists for both variable and fixed costs.
ILLUSTRATION 18-4 Linear behavior within relevant range
As you can see, although the linear (straight‐line) relationship may not be completely realistic, the linear assumption produces useful data for CVP analysis as long as the level of activity remains within the relevant range.
The relevant range is also called the normal or practical range.
Mixed costs are costs that contain both a variable‐ and a fixed‐cost element. Mixed costs, therefore, change in total but not proportionately with changes in the activity level.
The rental of a U‐Haul truck is a good example of a mixed cost. Assume that local rental terms for a 17‐foot truck, including insurance, are $50 per day plus 50 cents per mile. When determining the cost of a one‐day rental, the per day charge is a fixed cost (with respect to miles driven), whereas the mileage charge is a variable cost. The graphic presentation of the rental cost for a one‐day rental is shown in Illustration 18-5 (page 888).
ILLUSTRATION 18-5 Behavior of a mixed cost
In this case, the fixed‐cost element is the cost of having the service available. The variable‐cost element is the cost of actually using the service. Utility costs such as for electricity are another example of a mixed cost. Each month the electric bill includes a flat service fee plus a usage charge.
DO IT! 1
Types of Costs
Helena Company reports the following total costs at two levels of production.
|10,000 Units||20,000 Units|
Classify each cost as variable, fixed, or mixed.
✓ Recall that a variable cost varies in total directly and proportionately with each change in activity level.
✓ Recall that a fixed cost remains the same in total with each change in activity level.
✓ Recall that a mixed cost changes in total but not proportionately with each change in activity level.
Direct materials, direct labor, and indirect materials are variable costs.
Depreciation and rent are fixed costs.
Maintenance and utilities are mixed costs.
Related exercise material: BE18-1, BE18-2, E18-1, E18-2, E18-4, E18-6, and DO IT! 18-1.
LEARNING OBJECTIVE 2
Apply the high‐low method to determine the components of mixed costs.
For purposes of cost‐volume‐profit analysis, mixed costs must be classified into their fixed and variable elements. How does management make the classification? One possibility is to determine the variable and fixed components each time a mixed cost is incurred. But because of time and cost constraints, this approach is rarely followed. Instead, the usual approach is to collect data on the behavior of the mixed costs at various levels of activity. Analysts then identify the fixed‐ and variable‐cost components. Companies use various types of analysis. One type of analysis, called the high‐low method, is discussed next.