Cost-Behavior Patterns: Variable Costs and Fixed Costs

Learning Objective 3 Explain variable costs and fixed costs

• the two basic ways in which costs behave

Recall that the definition of a cost is the monetary value of resources (such as labor) sacrificed or forgone to achieve a specific objective, captured by the cost object. Costing systems record the cost of the resources acquired, such as materials, labor, and equipment, and track how those resources are used to achieve the cost object, such as to produce and sell a product or service. Managers can then observe how costs behave by comparing the level of costs to the volume, or the number of units achieved, of the cost object. There are two basic types of cost-behavior patterns. A variable cost of a cost object changes in its total level in proportion to changes in the volume, or number of units achieved, of the cost object. A fixed cost of a cost object remains unchanged in its total level for a given time period, despite wide changes in the volume, or number of units achieved, of the cost object. Note that costs are classified as variable or fixed with respect to a specific cost object and for a given time period. Identifying a cost as variable or fixed provides valuable information for making many management decisions and is an important input when evaluating performance. To illustrate these two basic types of cost-behavior patterns, again consider the costs at the Tesla Factory.

1. VARIABLE COSTS. If Tesla buys a steering wheel at $800 for each of its Tesla Model 3 vehicles, then the total cost of steering wheels is $800 times the number of vehicles produced, as the following table illustrates.

1. The steering wheel cost is an example of a variable cost with respect to the cost object Model 3 because the total cost of steering wheels changes in proportion to changes in the number of Model 3 vehicles produced. Note, however, that the cost per unit of the cost object of a variable cost is constant. For example, the cost per steering wheel in column 2 is the same regardless of whether 1,000 or 3,000 Model 3s are produced. As a result, the total cost of steering wheels in column 3 changes proportionately with the number of Model 3s produced in column 1. 
2. Panel A in Exhibit 2-3 shows a graph of the total costs of steering wheels. The costs are represented by the straight line that climbs from the bottom left corner to the top right corner of the graph. The phrases “strictly variable” or “proportionately variable” are sometimes used to describe the variable cost behavior shown in this panel: Zero units of the cost object have a variable cost of $0, and each additional unit of the cost object has the same incremental variable cost.

1. Now consider a different example: At the Tesla Factory, workers are paid a $20 hourly wage to set up machines. Is this cost a variable cost or a fixed cost with respect to the cost object machine setup-hour? The cost is a variable cost since the total wages for the workers change in proportion to the number of machine setup-hours used.

2. FIXED COSTS. Suppose Tesla incurs a total cost of $3,000,000 per year for supervisors who work exclusively on the Model 3 line. These costs are unchanged in total over a designated range of vehicles produced during a given time span (see Exhibit 2-3, Panel B). Note, however, that the fixed costs become smaller and smaller on a per-unit basis as the number of vehicles assembled increases, as the following table shows.

1. It is precisely because total line supervision costs are fixed at $3,000,000 that the fixed supervision cost per Model 3 decreases as the number of Model 3s produced increases; the same fixed costs are spread over a larger number of Model 3s. Be careful not to be misled by the change in fixed cost per unit. While the fixed cost per unit decreases as the number of units increases, total fixed costs remain unchanged. 
2. Why are some costs variable and other costs fixed? Recall that a cost is usually measured as the amount of money that must be paid to acquire the resources consumed. The cost of steering wheels is a variable cost because Tesla buys the steering wheels only when they are needed. As more Model 3s are produced, proportionately more steering wheels are acquired and proportionately more costs are incurred. 
3. Contrast the variable cost of steering wheels with the $3,000,000 of fixed cost per year incurred for the supervision of the Model 3 assembly line. This level of supervision is acquired and put in place well before Tesla uses it to produce Model 3s and before Tesla even knows how many Model 3s it will produce. Suppose that Tesla puts in place supervisors capable of supervising the production of 60,000 Model 3s each year. If the demand is for only 55,000 Model 3s, there will be idle capacity. Supervisors on the Model 3 line could have supervised the production of 60,000 Model 3s but will supervise only 55,000 Model 3s because of the lower demand. However, Tesla must pay for the unused line supervision capacity because the cost of supervision cannot be reduced in the short run. If demand is even lower—say only 50,000 Model 3s are demanded—the plant’s line supervision costs will still be $3,000,000, and its idle capacity will increase. 
4. Unlike variable costs, fixed costs of resources (such as for line supervision) cannot be quickly and easily changed to match changes in their demand. Over time, however, managers can take action to change a company’s fixed costs. For example, if the Model 3 line needs to be run for fewer hours because the demand for the vehicles falls, Tesla may lay off supervisors or move them to another production line. Unlike variable costs that go away automatically if resources are not deployed, reducing fixed costs requires active intervention on the part of managers. 
5. Do not assume that individual cost items are inherently variable or fixed. Consider labor costs. Labor costs can be purely variable for units produced when workers are paid on a piece-unit basis (for each unit they make). For example, some companies pay garment workers on a per-shirt-sewed basis, so the firms’ labor costs are purely variable. That is, total costs depend on how many shirts workers make. In contrast, other companies negotiate labor union agreements that include set annual salaries and no-layoff clauses for workers. At such a company, the salaries would appropriately be classified as fixed. For example, for decades, Japanese companies provided their workers a lifetime guarantee of employment. Although such a guarantee entails higher fixed labor costs, a firm can benefit because workers are more loyal and dedicated, which can improve productivity. However, during an economic downturn, the company risks losing money if revenues decrease while fixed costs remain unchanged. Following the global economic crisis of 2007–2009, companies have become very reluctant to lock in fixed costs. Concepts in Action: Lyft Helps Hospitals Reduce Their Fixed Transportation Costs describes how a ride-sharing service offers companies the opportunity to convert the fixed costs of owning corporate cars into variable costs by renting cars on an as-needed basis.

Furthermore, a particular cost item in a company could be variable with respect to one cost object and fixed with respect to another. Consider annual registration and license costs for a fleet of planes owned by an airline. Registration and license costs would be a variable cost with respect to the number of planes owned by the airline since each additional plane requires the airline to pay additional registration and license fees. But the registration and license costs would be a fixed cost with respect to the number of miles flown by one particular plane during a year since the total costs for registration and license remain the same, irrespective of the number of miles flown.

Some costs have both fixed and variable elements and are called mixed or semivariable costs. For example, a company’s telephone costs may consist of a fixed monthly base rate and an additional cost for each minute of calling. We discuss mixed costs and techniques to separate out their fixed and variable components in Chapter 10.

Cost Drivers

Recall that the total level of a variable cost changes, based on the volume, or number of units, of the cost object. Usually, there is a cause-and-effect relationship between a change in the volume of the cost object and a change in the total level of a variable cost. For example, a change in the number of Model 3 vehicles assembled causes a change in the total (variable) cost of steering wheels. In this case, the number of Model 3s is the cost driver of the total cost of steering wheels. A cost driver is a metric, such as the amount or volume of something or the level of an activity, that causally affects the level of a cost over a given time span. An activity is an event, task, or unit of work with a specified purpose—for example, designing products, setting up machines, or testing products. Consider other costs, such as product-design costs. What metric may causally drive the level of total product-design costs? For example, product-design costs may change with the number of parts in the product, which would be considered the product-design costs’ cost driver. Or consider distribution costs. The miles driven by trucks to deliver products are a cost driver of distribution costs.

Costs that are fixed in the short run have no cost driver in the short run since they remain unchanged. However, costs that are fixed in the short run may have a cost driver in the long run. Consider the costs of testing, say, 0.1% of the color printers produced at a Hewlett-Packard plant. These costs consist of equipment and staff costs of the testing department, which are difficult to change in the short run. Consequently, they are fixed in the short run regardless of how many color printers are produced at the plant (and hence tested). In this case, the production volume of color printers is not a cost driver of testing costs in the short run. In the long run, however, Hewlett-Packard will increase or decrease the testing department’s equipment and staff to the levels needed to support testing of 0.1% of future production volumes. In the long run, production volume of color printers is a cost driver of testing costs. Costing systems that identify the cost of activities such as testing, design, or setup are called activity-based costing systems.