Variable Costs and Fixed Costs

Variable Costs and Fixed Costs

Variable Costs and Fixed Costs

There has, however, been a growing realization that this simple method provides the manufacturer with a very limited picture of his true costs situation. He is prevented from devising a price policy which will maximize the profitability of his operations. A more sophisticated approach is the use of marginal costing, also known as contribution pricing. In this method, the costs involved in making the product are divided into two groups. First, there are those costs which vary with the volume of goods made and sold. These are known as variable costs. Secondly, there are those costs which remain static whatever the level of production and sales. These are called fixed costs. Variable costs may consist of the following:

1. Materials which are directly used in the production of the product.

2. Components which are bought from outside sources.

3. Labour directly employed in the production of the product.

4. Fuel and power used directly in the production of the product.

5. Carriage charges incurred in deliveries of the product.

6. Packing of the product.

7. Commission paid to salesmen and agents.

It will be seen that the total of these variable costs is the extra cost which the organization will incur in producing and selling an additional unit of the product. This additional production does not affect, materially, the company's overheads or fixed costs. Examples of fixed costs are:

1. The management of the business.

2. Salesmen's salaries and cars.

3. Rent, rates, lighting, heating, telephone.

4. Research and development.

5. Office expenses.

6. Advertising and promotion.

If the company is to make a profit out of its transactions, its fixed costs must be recovered from the marginal profit it receives on the sale of its products.

In a business which produces more than one product it is necessary to allocate overheads to each individual product.

Failure to do so can result in a very misleading picture of the profitability of the overall operation.

The contribution which will be made by the sale of the product to the recovery of fixed costs and, subsequently, the profits of the organization, is the difference between its selling price and the variable cost. From this it will be seen that there are times when, to make a sale at any price which is in excess of variable cost can be a better course than that of making no sale at all, in spite of the fact that an overall profit is not achieved. One could not run a profitable business on this basis. To do so would incur a net loss, although this loss would, of course, be smaller than if there had been no sales whatever.

Thus an examination of total costs in relation to fixed costs and sales will indicate a break-even point. It is above this point that prices can, if one wishes, be cut if it is considered that such a move will attract additional sales.

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Please Note

The Trade is, of course, a major source of product ideas. All manufacturers examine, with avid interest, the new products of their competitors.