Every business in today’s world has one goal in mind; to maximize their overall profits and drive their business into the future. So to accomplish this goal, you will want to keep in mind as to what types of costs affect your business the most and how to effectively control those costs for reporting purposes. To start us off, let’s first define fixed and variable costs.
Fixed costs are the costs that are not directly related to the level of output or production. These are costs that, no matter the amount of activity, they will remain the same and do not change. Some examples may include: rent, depreciation, research and development, administration/office salaries, advertising, office utilities, sales salaries, and office supplies. Variable costs are costs that are directly related to the products and change with the levels of output. Some examples of variables costs a business may have are raw materials, sales commissions, salaries to production workers, and utilities used in manufacturing. It is important to note that some costs may be changed to make their activity fixed or variable. For instance, your sales salaries, which are commonly a fixed cost, can be changed to a variable cost by having your sales force work on commission instead of a base pay.
Now that we have a basic understanding of what fixed and variable cost are, let’s take a look at what type of cost structure might be appropriate for your business’s overall needs. There are currently two types of cost structures businesses use most; fixed and variable.
Fixed cost structures deal solely with a focus on the fixed costs associated with a company’s operations. This type of structure has unlimited profitability potential and unlimited risks. In a totally fixed cost structure, if your sales increase your costs will remain the same, thereby, allowing your company to achieve high profits. But if your company’s sales decrease for any reason, your company can incur a huge loss because the costs, again, are going to remain stable. Overall, a fixed cost structure is most beneficial to companies that frequently experience increases in their sales volume.
A variable cost structure places its main focus on the variable costs affecting a business. There is little risk associated with a variable cost structure because as sales go up the costs rise with it and when sales go down the costs decrease. In fact the complete risk of this cost structure mainly lies with the suppliers, because if the business doesn’t sell any products, the supplier does not get any business. This cost structure is the most predictable for management because it allows a business to predict sales and costs more accurately then a fixed cost structure allows. Overall, this costs structure is most beneficial to companies with a decreasing sales volume.
As you can see, both cost structures have their pros and cons. But before you make a final decision as to which cost structure is best for your company, I would like to discuss a little about product costing analysis, which will give you a better understanding of which cost structure may be best for your business and its future needs.
The product costing in a manufacturing organization includes all the direct (fixed) and indirect (variable) costs of making the product and these costs are treated as inventory. The GAAP (Generally Accepted Accounting Principles) requires that all product costs (fixed or variable) be accumulated in the inventory until the inventory is sold. The product costs are then expensed, as products are sold, by calculating the cost of goods sold. This practice is known as absorption costing. Under full absorption costing, the only costs that appear on the income statement are the cost of goods sold account. Results reported under this costing method can tempt management to produce more products than the company can sell, because the fixed overhead costs can be spread over or absorbed by more units. This will improve the gross profit margin and make the manufacturing process look more profitable. Beware though; this type of practice causes management to overproduce which leads to a buildup in the inventory account. This can lead to extra costs (i.e. storage costs), risks (i.e. to many products for company to sell in one period), and reduce a company’s overall profitability in the long run. So for this reason companies will use what is known as variable costing analysis for internal reporting purposes.
Variable costing analysis excludes fixed costs, which will encourage management not to overproduce. The fixed costs are treated as an expense under your contribution margin and by using this costing method you will see an overall improvement in the contribution margin. This is because this method tempts you not to overproduce, thereby, shows an improvement in production and decreases variable costs. This gives a company an advantage on maintaining their long-term profitability picture.
The GAAP requires companies to use absorption costing for financial reporting purposes, but has no regulation as to which method companies use in reporting for internal purposes. So because of the pros and cons of both methods, many businesses use variable costing for internal reporting purposes and use absorption costing for external reporting purposes.
With all that said, I would recommend that if you are a small company who experiences more variable costs, have a low sales volume, and has a hard time being able to predict the market trends; then I would recommend you use the variable costing structure and variable analysis for internal reporting purposes. Under a variable cost structure, you will be able to accurately predict your company’s profitability in a given time period and using variable analysis for internal reporting purposes, you will not be tempted to overproduce.
On the other hand, if you are a company that sells several products in one given time period and experiences a high volume of fixed costs, then I would recommend using a fixed cost structure and absorption costing for your reporting purposes. These methods will allow you to achieve higher profits and make your operations look more profitable, because your costs will remain the same no matter your level of output.
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