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Analysis OF The Difference Between Fixed Cost And Variable Cost Add in library

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Question :

Analyse the difference between fixed and variable costs. What is the relationship of these costs with volume and profit? Discuss the use of break-even analysis as a technique for evaluating business decisions, and describe and evaluate its benefits and weaknesses.

 

 

Answer :

Fixed cost refers to the expenditure which is constant for different levels of production and sales. However, fixed costs will change over time with the changes n external factors. Fixed cost is independent of output or sales of the business organization. For example salary of the employees, rent for the space, insurance premium, depreciation etc (Neish and Banks, 2010). The following graph demonstrates fixed cost:

Variable cost refers to the cost which fluctuates with the change in production level, sales etc. The variable cost is dependent on other factors and it has been observed that this cost varies in a specific proportion. Variable cost is responsible for changing the total cost of a product. Example of variable cost includes cost of material, wages paid to the labors, incentives to the sales representatives etc (Jagels, Coltman and Coltman, 2004).

 

In the following diagram, variable cost is represented:

Relationship of the Cost with Volume and Profit

Relationship with cost, volume and profit can be established with the aid of a technique, Cost Volume Profit (CVP) analysis. The management accounting tool emphasizes on analyzing the impact of sales volume and cost of goods sold on the operating profit of the business firm. First of all, the assumptions of CVP analysis must be considered. CVP analysis assumes that all cost can be segmented as fixed or variable cost. This analysis holds for the situation when the fixed cost, variable cost per unit and selling price per unit are constant (Hart, Wilson and Fergus, 2008). The third assumption of CVP analysis is: all the produced units are sold.

 

The profit equation is given below:

P*X=Vc*X +Fc +Profit

In the above equation,

P = Selling price of the product

X = Output/ Sales

Vc = Variable Cost

Fc = Fixed Cost

Putting the values in the equation, the profit can be calculated for different levels of output.

 

Contribution margin can be calculated for analyzing the relationship between cost, volume and profit. In this method, contribution margin will imply the profit of the company before considering the fixed cost (Neish and Banks, 2010). Contribution margin can be calculated with the aid of the following formula:

Contribution Margin = Total Sales -Total Variable Cost 

On the other hand unit contribution margin can be calculated by considering the following formula:

Unit Contribution Margin = Selling price per unit - Variable cost per unit

Thus the contribution margin can be calculated for understanding the proportion of variable cost and selling price.

Additionally, contribution margin ratio can be estimated with the aid of the following formula:

Contribution Margin Ratio = Total Sales/Unit Contribution Margin

High Contribution margin ratio implies that the unit contribution is low or the variable cost is high. On the other hand, low contribution margin ratio indicates that the unit contribution margin is high or the variable cost is low (Jagels, Coltman and Coltman, 2004).

Break-even Analysis

Break even analysis is a useful tool that helps the management accountants and production management in managing the activities effectively.  Break even analysis focuses on identification of the point at which the company does not make profit or loss. The breakeven point is completely dependent on the level of production, selling price of the product, variable cost and the fixed cost (Hart, Wilson and Fergus, 2008). Breakeven point can be calculated in terms of sales volume in units or in monetary value. At the breakeven point,

Profit = 0

In the equation of CVP, the value of profit can be substituted by ‘zero’ and formula for calculating break even can be calculated. The following formula can be used for estimating break even sales (Hansen and Mowen, 2000):

 

 

Breakeven Sales (in units) = Fixed cost/Selling price per unit - variable cost per unit 

Breakeven Sales (in amount) = Selling price per unit X Break even sales in units

Advantages

1. Breakeven point is very useful in identifying the point at which the business firm will not incur profit or loss.
2. Break even analysis helps in estimation of profit at different level of output.
3. Break even analysis helps in predicting the impact of price change.
4. Breakeven point also helps in anticipating the impact of change in efficiency and cost on profitability (Epstein and Lee, 2011).
5. Break even analysis is a helpful tool in analyzing the correlation between the profit with different cost.

Weaknesses

1. Breakeven analysis only considers the perspective of suppliers and it does not give any idea regarding sales volume.
2. In break even analysis, fixed cost is considered to be constant. However, it must be noted that in long run, fixed cost changes.
3. Additionally, it is assumed that the output of the mount produced by the business firm is completely sold by the business firm. However, in reality this situation might not take place. Hence, calculation of the breakeven point will be erroneous.
4. Break even analysis can be only applied to single product of product mix where the proportion of products are same (Coombs, Hobbs and Jenkins, 2005).

 

 

References

Coombs, H., Hobbs, D. and Jenkins, D. (2005). Management accounting. London: SAGE Publications.

Epstein, M. and Lee, J. (2011). Advances in management accounting. Bingley, UK: Emerald.

Hansen, D. and Mowen, M. (2000). Management accounting. Cincinnati: South-Western College Pub.

Hart, J., Wilson, C. and Fergus, C. (2008). Management accounting. Frenchs Forest, N.S.W.: Pearson Education Australia.

Jagels, M., Coltman, M. and Coltman, M. (2004). Hospitality management accounting. Hoboken, N.J.: J. Wiley.

Neish, W. and Banks, A. (2010). Management accounting. North Ryde, N.S.W.: McGraw-Hill.

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