Knowing how costs change as volume or activities change is helpful when making business decisions. For example, if most of a product's costs are fixed, then a company's total costs will increase only slightly when more units are produced and sold. Understanding this cost behavior might lead to special promotions that will increase profits and sales.
Costs and expenses that do not increase with reasonable increases in volume are known as fixed costs. Examples of fixed costs are the salaries of managers, property tax, and depreciation.
Costs and expenses that increase in total as volume increases are variable costs and expenses. A product's direct materials, direct labor, and some overhead costs are variable costs. Two examples of variable overhead costs are the electricity to power the equipment in the manufacturing process and factory supplies.
Some costs are mixed costs, which means partly fixed and partly variable. An example might be maintenance costs. You can determine how much of a mixed cost is fixed and how much is variable by using several techniques. One technique is to plot the costs on a graph where the y-axis is the total cost and the x-axis is the amount of volume or activity. If the plotted points form a straight line, you can extend the line through the y-axis. The point where the line intersects the y-axis is the amount of the fixed cost.
Another technique is the high-low method. With this method, you compare the total cost at the highest level of activity to the total cost at the lowest level of activity. The variable cost rate is the difference in total cost divided by the difference in the volume of activity.
A more sophisticated technique for separating the fixed and variable costs in a mixed cost is regression analysis. This technique computes the best fitting line through the plotted points by utilizing the least-squares method.
Break-even analysis utilizes the concept known as contribution margin. Contribution margin is defined as sales dollars minus variable costs and variable expenses. If a product sells for $10 and its variable costs and variable expenses are $6, the contribution margin is $4 per unit. The formula for the break-even point in units of product is the total fixed costs divided by the contribution margin per unit. For example, if the total fixed costs are $40,000 and the contribution margin per unit is $4, the break-even point is 10,000 units ($40,000 divided by $4).
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Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is the sole author of all the materials on AccountingCoach.com. Read more about the author.