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There are many types of cost you might have to consider in budgeting and managing your team’s financial performance. This document gives you a quick overview and examples of fixed and variable costs and also sunk and opportunity costs.
What is a Fixed Cost?
Whether a cost is fixed or variable depends on the period of time being measured.
A cost is fixed if it will not vary with the level of work or production that is taking place during a given period of time.
Usually, fixed costs are items such as property costs, rental and insurance.
What is a Variable Cost?
A variable cost varies in direct proportion to activity.
Variable costs are usually expenses such as material and labor.
Are There Any Gray Areas?
In reality, labor is rarely a truly variable cost because, if production or service stops, there will still be some labor costs that require to be met. People who are already on that shift or payroll will still be paid even if they are not working at full capacity.
What is the Total Cost of Producing Your Products/Services?
Using the formula below, work through this example to see how to calculate your total costs.
Total cost = Total fixed costs + total variable costs
Fernie Ltd makes widgets and produces 500 in the first month of the financial year. Listed below are Fernie Ltd’s variable and fixed costs:
Variable costs per item
Labor
£15
Materials
£10
Energy costs
£1
Total variable costs per item
£26
Variable costs to produce 500 items
£13,000
Fixed costs for the period
Property costs
£10,000
Machine rental
£5,000
Insurance
£500
Total fixed costs
£15,500
Total cost of production (variable + fixed)
£28,500
How Can You Use This Information?
Knowing this information allows you to work out things such as the price that you need to charge or the volume that you will need to sell in order to break-even or to make a profit.
For instance, if the maximum price the market will allow you to charge is £50 then producing and selling 500 units will produce income of only £25,000 and an overall loss of £3,500.
A good way to find the break-even point is to graph the income and total cost and find where they cross.
In this case, the break-even point is between 600 and 700 units.
Another method to work out the exact break-even point is to work out the contribution margin and then divide the fixed costs by this figure.
Contribution margin = Price – Total variable cost
In our example:
Contribution margin = £50 - £26 = £24
Therefore, the total number of units that need to be sold is:
15,500/24 = 646.
Another term sometimes used for the total variable cost is marginal cost.
Standard and Actual Costs
You may often be expected to manage a process that has standard costs. This is the expected cost of a process. This is then compared to the actual cost incurred and the difference is called a variance. People who manage budgets are often called upon to justify variances beyond a certain level.
An example:
The expected cost of producing 500 units is £5,000
The actual costs and variances across three months are:
Month
£
Variance
Reason
1
5,000
0
N/A as no variance
2
5,025
25
Below limit
3
5,500
500
Machine breakdown
Sunk Costs
Sunk costs can be termed as past costs. A sunk cost is cost that has already been incurred so should be irrelevant to the decision-making process when costing decisions. Sometimes this is difficult because emotionally you may feel that you need to demonstrate that a previous cost has been worthwhile.
Sunk costs also include future expenditure to which an organization is irrevocably committed and which therefore cannot be avoided by taking any action.
An example:
Three months ago you invested £100,000 in a new software package that has improved productivity and will pay for itself over a three-year period. Unexpectedly, a totally new software package is released which will improve profitability dramatically and pay for itself over a period of 18 months, but it makes the original £100,000 investment worthless.
In making the decision to invest in the new software, you should ignore the previous expenditure of £100,000 as it is a sunk cost. The decision to invest should be made only on the expected payback of the new software package.
Opportunity Costs
An opportunity cost is the term used to describe the maximum contribution to profit that is forgone in the event of a choice between one or more options. It is seldom expressed in formal accounting statements, but it is important to consider in making decisions.
An example:
A firm has two employees, Smith and Jones, who make a simple product. As the cost of the material is the same in this example whatever the choice, we will ignore this cost.
The firm has an opportunity to divert Smith to another job for which she can be charged out at double her salary. To undertake Smith’s work the organization has to employ Brown at 50% more of a cost.
The alternatives are:
Smith not diverted to other work
Smith diverted to other work
Difference
Revenue for goods
400
400
0
Revenue for Smith's assignment
200
200
Total Revenue
100
600
200
Costs
Smith
100
100
Jones
100
100
Brown
150
Total Costs
200
350
150
Profit/Loss
200
250
50
Another way to look at this is to consider the impact of proceeding by stating Brown’s additional costs as the opportunity costs:
Normal Revenue
400
Normal costs
200
Opportunity costs
150
Total Costs
350
Profit Effect
50
