Fixed and variable costs

Every decision about price or volume depends on knowing which costs go up when the business does more of something. A cost that rises in proportion to activity is variable. A cost that stays the same across a range of activity is fixed. Most decisions in this module come down to sorting costs into those two groups correctly.

Behaviour depends on the activity you measure

A cost is fixed or variable only in relation to a stated measure of activity, called the cost driver. For a cafe the driver is usually cups or items sold. For a plumbing company it is usually billable hours. Milk is variable with lattes sold. Rent is fixed with lattes sold. A plumber's salary is fixed with billable hours, because the plumber is paid for 2,000 hours whether 1,200 or 1,900 of them are billed.

This last point is easy to miss in a service business. Wages feel variable because they are tied to people working, but if staff are salaried or guaranteed hours, wages don't change when one more job comes in. They change when the business hires or lets someone go.

The relevant range

Fixed costs are fixed only within a range of activity. Hartley's three plumbers can bill at most around 6,000 hours a year between them, and realistically fewer. Beyond that the company needs a fourth plumber and a fourth van, and fixed costs jump. The range over which the cost assumptions hold is the relevant range. Every cost model should state its range, and any decision that moves outside it needs a new model.

Mixed costs

Many costs have a fixed part and a variable part. A van has a lease payment that is the same every month and fuel that rises with kilometres driven. A phone plan has a base fee plus usage. To plan with a mixed cost, split it into its two parts.

Total cost = Fixed cost + (Variable cost per unit × Units)

The high-low method

The high-low method splits a mixed cost using two observations: the period with the highest activity and the period with the lowest.

Variable cost per unit = (Cost at high − Cost at low) ÷ (Activity at high − Activity at low)

Fixed cost = Cost at high − (Variable cost per unit × Activity at high)

It is quick and needs only two numbers, which is also its weakness. If either month was unusual, the estimate is off. Choose the high and low points by activity, not by cost, and look at the other months to see whether they sit close to the resulting line. Regression analysis uses every observation and gives a better estimate when you have more than a handful of periods; spreadsheet software can do it with a single function such as SLOPE and INTERCEPT. OpenStax's Principles of Managerial Accounting covers both methods.

Step costs

Some costs are fixed over a narrow band and then jump. A second espresso machine, a part-time supervisor, a larger storage unit. Treat each step as a fixed cost within its band, and note where the next step begins. Many growth plans fail because they assumed a cost would stay flat past a step.