Integral Logistics Management — Operations Management and Supply Chain Management Within and Across Companies

16.1.3 Variable Costs and Fixed Costs

Intended learning outcomes: Differentiate between variable costs and fixed costs. Describe step-function costs. Identify full costs.

Variable costs for a product or an order only incur if the company actually makes or buys a product. Variable costs include all costs generated directly by the order, e.g., the wages of production workers or salespeople, the cost of raw materials or purchased components, subcontracted operations, or electric power to run machines.

As a rule of thumb, the following statement applies:

“Variable costs are all those costs that would not be incurred if we did not produce or procure anything.”

The fixed costs for a product or order are the costs that are not variable; they remain the same regardless of the level of production and sales.

Fixed costs remain constant even when activity levels change. Some typical examples in­clu­de the production infrastructure (buildings, depreciation, property taxes, mortgage pay­ments, insurance, salaries of foremen or departmental managers, heating), R&D, and so on.

Of course, fixed costs are “fixed” only for a certain period of time. Above this time threshold, they show step-wise jumps.

Step-function costs or semifixed costs have a habit of jumping in a step-wise fashion over time. For example, demand — and thus production — may increase and require a company to purchase new production equipment or to rent or purchase an additional building. Investments in infrastructure improvement or the hiring of new personnel will result in smaller step-wise jumps in the cost curve.

It is common practice to capitalize and depreciate investments that will be used for more than one year. Depreciation costs and ongoing fixed costs per year must be allocated to indi­vidual orders using a formula or measure as the basis of apportionment. See Section 16.1.4.

In most cases, direct costs are variable costs as defined above. Overhead costs are normally fixed costs.

However, costs are defined as fixed or variable with respect to specific cost objects. Therefore, some overhead costs can be variable, such as the cost of the energy used directly for the production process. A (rare) example of direct fixed costs is the capital costs that can be allocated directly to a production contract, such as fixed annual license fees.

Full costs for a product or order are the sum of the variable costs plus a reasonable portion of the fixed costs.

This reasonable allocation of fixed costs to products or orders entails the same problem as the “fair” distribution of fixed costs does. It is not possible in this chapter to go into the advantages and disadvantages of variable costing or full costing; a large body of literature is available on the topic. In general, though, it is important that the company can perform calculations using both of these costing principles. Furthermore, there are specific requirements for external financial reporting.

Course section 16.1: Subsections and their intended learning outcomes