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Oct 07 2013

How to calculate variable and fixed costs in business

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     We have repeatedly mentioned that the company carries out a number of costs in the normal course of business. There are different classifications of costs according to the type of resources spent, time of occurrence, etc. We’ll talk about the specific of costs, depending on their characteristics related to the volume of activity today.

Company activity is not stable, production or sales may increase or decrease. Dimensions of revenue also change.

All costs of the company can be divided into two groups: variable costs and fixed costs.

Variable costs definition.

Costs that vary with the change in activity called variable costs.

Fixed costs definition.

Costs that remain constant regardless of the volume of activity called fixed costs.

The main variable costs most often include:

  • Raw materials costs. Raw materials consumed in the production by certain norms. The change in output leads to changes in costs of raw materials. It should be noted that the total amount of material costs can change, but costs per unit remain stable.
  • Costs of energy and fuel. These expenses vary as well as the cost of raw materials, while per unit they are stable too.
  • Production workers labor costs. These costs are variable, if the wages of production workers is based on their output (sales). If wages made by the base salary system these costs are constant.
  • Social fund payment costs. These expenses are variable if the costs of production workers labor are variable. If labor costs are constant, these costs are also constant.

The main fixed costs in business include the following costs:

  • Depreciation costs. Depreciation charges don’t depend on the volume of activity, except in cases where depreciation is calculated by production method.
  • Salaries of administrative staff. Administrative staff receives a stable salary in most cases.
  • Social charges on salaries of administrative staff. These costs are also mostly stable, as well as administrative staff salaries.
  • Utility services and security. The company must pay for utilities (except electricity or water for industrial purposes) and security, regardless of the volume of activity.
  • Leases. If a company has leased certain fixed assets rental costs will also belong to the fixed costs.

Each company may have other fixed and variable costs depending on the specifics of its activities.

Total business expenses of the company can be described by the formula:

Tc = Fc + VcU x P,

Tc – total costs of the company,

Fc – total fixed costs of the company,

VcU – variable cost per unit of production,

P – number of product units.

A fixed and variable costs analysis cost allows determining impact of changes in the cost of production and therefore the profitability of the company.

Indicator of operating leverage calculated for this.

Formula for operating leverage:

Lo = (Rt – Vc)/Pr  ,

Lo – operating leverage,

Rt – total revenue,

Vc – variable costs,

Pr – profit.

This indicator allows predicting the changes in the profit of the company due to the changes in volumes of realization.

For example.

Rate of operational leverage is 1.5. It means that with an increase in sales on 1% profit will increase on 1.5% and vice versa – with a decrease of sales level on 1% profit will decrease on 1.5%.

     Company cost management system should provide the division of all costs into fixed and variable costs, as well as monitoring of their impact on profitability.

1 comment
  1. Doroti Lins

    Types of costs is a very interesting in business-planning, so every financial manager must take them on mind.

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