In cost accounting, product costs behave in two ways. According to Crosson and Needles, the cost of a product can either increase or remain static. A variable cost, as Mowen, Hansen, and Heitger explains, is the change of cost of a service or a product and how it affects the expenditure of a company. Both have advantages and disadvantages.
Fixed cost establishes a price point over a period of time. One of the advantages of fixed pricing is that it attracts repeat customers. Crosson and Needles indicate that fixed cost attracts several new customers as well as repeat clients because it offers assurance. Prospective clients are able to determine beforehand what they are going to pay for a service or product. This gives them a guarantee.
Horngren, Datar, and Rajan indicate that fixed costs create consistency. Individuals and clients get accustomed to an established price. This consistency lowers the risk of fluctuations which offends and drives clients away. Moreover, fixed cost enables sales forecasting. Horngren et al. further indicate that with such stability, profit estimates, as well as sales forecasts, can be made easily.
Horngren et al. point out that variables are important in developing an understanding of how net profits are affected by fixed costs. Therefore, in an income statement, variables are critical in determining total fixed costs. It is imperative to highlight that a variable costing system is used to control flexible budget costs.
In management accounting, a variable costing system provides cost volume profit (CVP) analysis information necessary for the preparation of income statements. This is an advantage over an absorption costing system. The latter cannot be used to obtain direct data. Moreover, expenses a company will incur may be on an as-needed basis. The net loss or net income will be determined by the fixed cost in the income statement. A fixed cost option lowers a variable cost.
On the other hand, fixed and variable costs have numerous disadvantages. One such disadvantage, as Hansen and Mowen note, is a lack of flexibility. It does not allow adjustments. The effect is that the cost basis for a product or a service becomes higher. Besides, fixed cost does not factor in additional work or changes in time or cost. As such, a customer only pays for a product or service based on an established cost. As a result, a client may be undercharged for overtime service.
Additionally, under variable costing, financial statements prepared do not follow accepted accounting principles. It also does not follow a number of tax laws. Both variable and fixed costs ignore the cost of manufacturing items. This revenue cannot be matched with the production costs.