Finance for Non-Financial Managers: Costing decisions

Dave JoneseLearning, Finance for Non-Financial Managers1 Comment

fixed and variable costs

A short guide on costing decisions for Non-Financial Managers…

Fixed and variable costs

Fixed and variable costs

Distinguishing between fixed and variable costs can help in assessing a business’ risk profile. It can also help managers within a company make decisions about product mixes and prices.

  • Definition of a fixed cost: a cost that remains fixed in monetary terms as the volume of business either rises or falls.
  • Definition of a variable cost: a cost that varies in monetary terms as the volume of business either rises or falls.

In practice, classifying costs into ‘fixed’ and ‘variable’ categories can sometimes only be done on an approximate basis.

Companies are less vulnerable to a decline in sales if most of their costs are variable – and so will fall along with levels of production. But they will continue to have high fixed costs irrespective of how much they are selling.

Contribution

Contribution
Contribution is defined as the level of profit reached by taking variable costs away from sales.

In a business with low fixed and high variable costs, the value of contribution will be relatively small: however, for companies with low variable costs, contribution will be high.

Contribution can be used to directly compare the cost structures of companies in its simple form.

But in practice it is easier to measure something called the ‘contribution ratio’ = contribution x 100% / sales.

A low contribution ratio can imply low fixed costs, which caps risks if volumes decline, but limits the upside for profits if sales increase.

Variable and Full Costing

Variable and full costing
Companies can use either a variable costing or full costing approach when it comes to calculating unit cost.

Variable costing treats variable and fixed costs on a separate basis. Variable costs are taken away from Sales to produce Contribution. Fixed costs are then taken away from Contribution to arrive at Operating Profit.

Full costing provides an alternative approach. Here, variable costs and fixed cost of sales (e.g. Cost of Sales) are deducted from Sales to arrive at Gross Profit. Then variable and fixed overheads (e.g. Expenses) are taken away to calculate Operating Profit.

Variable costing allows a business to answer many key questions about its operations such as:

  • What is the number of units that must be sold to generate a given profit level?;
  • What is the sales volume at which the business will break even?;
  • How will a defined fall in price – and a consequent increase in unit sales volumes – affect the business?

Although variable costing is useful to support decisions relating to incremental production volumes, it should NOT be the only costing method used by a business. This is because it is always important to take account of fixed costs, even when variable costing is the approach being used for a particular decision.

Break Even

Break-even

Understanding what their break-even point is makes businesses less vulnerable to declines in sales.

The break-even point for a product is defined as being when operating profits are zero.

Under a variable costing approach, this happens when contribution falls with sales, to a level where it is equal to fixed costs.

So a business wants to know what the level of sales needs to be where the level of contribution is enough to cover its fixed costs: or in other words, where sales are equal to total costs.

The ‘relevant range’ is the range within which the break-even point can be determined by a simple comparison of total sales and costs. This is because fixed costs may rise when production increases beyond a certain level. Therefore break-even will actually occur when:

(selling price per unit) x (no. of units sold) – (variable cost per unit) x (no. of units sold) – (fixed costs) = 0.

This can be simplified to an equation stating that break-even occurs when:

(contribution per unit) x (no. of units sold) – fixed costs = 0.

So, given this: no. of sale units required for break-even = fixed costs/contribution per unit.

The break-even formula calculates how many units need to be sold to generate an operating profit of zero:

units to break-even = fixed costs/contribution per unit.

However, it is always the case that:

Contribution = Fixed costs + Operating Profit.

So given this, it is also true that:

Units to sell = Fixed costs + required Operating Profit/Contribution per unit.

When unit prices – and sales levels – change, the new level of Operating Profit can be calculated as follows:

Operating profit = (Contribution/unit x Units sold) – Fixed costs.

What about a situation where a business needs to know the amount of sales revenue that will produce a given level of operating profit, but doesn’t know how many units must be sold? Here:

$ to sell = Fixed costs + required Operating Profit / Contribution per $ of sales.

Product Costing

Product Costing

The contribution ratio is a vital method for companies trying to set the right product mix to optimise financial results.

Following such analysis, they should always concentrate on maximising the sales of the products they produce which have the highest contribution ratio percentages.

Ideally, they will also identify all of the limiting factors involved in production – such as the availability of skilled labour – and work out the contribution percentages for those factors.

Doing so will then reveal what is truly the most profitable product, and in turn maximise the business’ operating profits.

Even if a product appears to be losing money (on the basis of allocating fixed costs on a sales basis) a business should always usually continue making products that make a contribution (as allocating fixed costs on a sales basis is not necessarily reflective of the full costs of a product).

The exceptions to this are a) unless the resources released by ceasing production can be used more profitably elsewhere or b) if fixed costs savings make up for the contribution that is lost.

If solid projections can be made concerning the impact of price changes on sales volumes, contribution is very useful in identifying optimum product prices.

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