Fixed is Fixed… Is it not?

. Lets take a simplistic look at his:

You will find that the most common way to think about cost price is to take costs + cost per unit equals . Add to that you other SG&A to get to fully loaded cost per unit. Add to that the profit margin to get to your selling price.

Symplicstically said the for the first part (standard cost per unit) is as follows:

Fixed Cost + Variable Cost per unit = Standard Cost per Unit
Volume

What is important here is to realize that per unit are not fixed, they go down when volume drops. Variable costs per unit on the contrary are fixed.

Lets look at an example.

Production volume is expected to be 500. Variable Mfg Costs are 4 per piece and Fixed Mfg Costs are 15.000. At the beginning of the year we set our standard cost to be Variable costs per unit are thus 4 and Fixed costs per unit 15.000/500 = 30. Total standard cost per unit = 34.

Now during the year, production volume changes to 1.000, total variable costs will (variable means: costs increase when production volume increases). So Variable costs per unit are still 4 (no change). Fixed costs per unit however have now halved to 15.000/1.000 = 15. cost price is now only 19. Quite favorable situation as you are recovering more fixed costs than planned.

Why is this important? Fixed expenses are absorbed completely by producing the volume you set when determining your fixed cost per unit (usually once per year). If you are producing below the volumes expected you will not recover enough fixed costs (the absorption is too low). This will show up in the P&L on the absorption line in the variance section called Volume Variance”, leaving you at a loss. Of course vise versa is true as well as is in this example above. Having higher volumes produced compared to plan means you recover more fixed costs than needed.

There is another type of variance that may occur around fixed costs. It may be that your fixed costs spending pattern does not happen the way you planned it out to be. E.g. if your insurance suddenly gets increased, or your rental agent gives you a reduction in price. The 15.000 of Fixed costs above could suddenly be very different, even though we thought they were fixed. In that case you will have a positive or negative impact on the P&L called “Overhead Spend Variance”.

In Summary:
Variable costs move with production volume (1 more unit produced = (depending on the correlation) 1 more variable cost). Variable costs per unit do not change. It is abosolutely key to make sure this relation is true as assumed at the beginning of the year. Why? Because if you think something is variable and its not in reality you may come to stand for surprises when volumes drop or increase.

Total Fixed costs are expected not to change when output changes (1 more unit produced = same level of fixed costs). Fixed costs per unit however do move with volume produced. If you do not meet the levels of volume set at the beginning of the year when building your standard cost, you will see a loss in the P&L on the variance line (absorption).

If you believe fixed is not fixed, tell the world, let us know and leave a comment!


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