Variable cost analysis is very crucial when we come to decision making. Variable costs do affect the profitability of every organization thus managers are encouraged to decrease variable costs in order to maintain good profitability (Drury, 2007). Analysis of variable costs will therefore enable the manager to devise ways of reducing the variable costs. Some of the decisions which the manager might be encouraged to take after the variable cost analysis include: keeping wastage at a minimal level, advancing to new technologies, recycling with an aim of reducing wastage to a zero level, and using cheaper raw materials. Variable costs in most cases vary with the decision (FAO, 2006). Whenever a decision is made to counter the effects of variable costs, these costs will directly be affected by such decisions. Variable costs are normally considered to be the costs associated with direct material, direct expenses, direct labor and overheads variable parts.
Effects of Variable Costs when making a cost decision
Variable costs are costs which change in direct proportion to the variations of a certain business activity or output. All activities cause varying costs because if there are no activities, there will be no variable costs. For instance, increase in production will lead to an increase in direct labor costs and direct overheads costs. An increase in sales will increase the sales commission. In this context, a manager is supposed to consider all the factors in order to make the best decision. When an organization is faced with a problem, the manager must vary the relevant qualitative and quantitative costs to make the best decision.
Organization managers must control the previous, current and the future organization costs for better management of the business (Weygandt, 2009). Organizations which try to maximize the profit earnings, controlling costs affects them directly because the product cost must be considered while making a decision. The variable costs of a company consist of direct labor and direct overhead costs, supplying costs, packing costs, commission costs and travelling costs. A reduction of wastes will lead to reduction of labor costs. When a manager understands the cost behavior as production and sales changes, he/she will be in a position to plan, manage cost and make good decisions.
One of the most unstable variables in an organization is its volume, which includes the total products brought forth, and the total amount of the product which has been sold (Weygandt, 2009). Any variation of volume will have a direct effect on the variable costs though the connection between all the variable costs and the volume is determined by managers through assumption. A manager is supposed to be able to recognize and measure the variable costs from the organization cost data as this will help him/her to make the correct informed decisions.
Variable costs rise or reduce with the activity since there is always a fixed connection between the cost factors and the particular unit of an activity. In addition, any rise in total cost will lead to rise in volume. There are some circumstances where managers when exercising their decisional making powers, some costs are transformed to variable or fixed. For instance, Compensating sales people could be turned to either variable or fixed. When the management opts to give the sales people a reward as a commission, then this compensation is said to be variable. But if they decide to compensate the sales people in terms of salary, the compensation will be fixed.
Variable cost and sales volume Analysis in relation to the cost of the operating income
The cost, volume and profit analysis involves the evaluation of the connection that exists between the sale price, production output costs, sales, overheads and the profit. During this analysis various assumptions are always made such as: the selling price per unit is assumed to be constant, varying costs per unit is assumed to be constant, full fixed cost is assumed to be constant, and the entire products produced must be sold (Hansen, 2007). All costs change due to the changing business activities and when an organization is selling many products, they sell in the same products mix. This analysis offers the organization manager with important data which he/she uses for decision making. For instance, the analysis could be used in establishment of the selling prices, in decision making for choosing the marketing plans, in the selection of the product mix for selling and in the evaluation of the profit changes due to the costs (Hansen, 2007). In this competitive business environment, the organization manager must make the business decisions vey fast and accurately due to the increasing importance of cost, volume, and profit analysis.
Contribution margin is the connection between the cost-volume and profit of a company. It is the excess profit generated from sales in excess of the variable costs. Margin contribution conception is very important during forecasting of the business as it offers an understanding of the possible profits which could be generated by a business. There is also unit contribution margin which is very important in analyzing the possible profits of the planned projects. It is the profit of every unit from the available sales for covering the operating fixed costs and generating the operational profits.
This analysis involves the contribution margin. It is easier to evaluate than the unit contribution margin especially when an organization sells various products. Another basic of cost, volume and profit analysis is the break-even point (Arsham, 2007). This is a point where the company profit is zero. It is appoint where all the sales are equal to all expenses. Profit analysis deals with assessing the required sales in order to achieve the specific targeted profit. The cost, volume and profit analysis helps the manager to understand the organizations cost structure which is very useful for his/ her decision making as this is the relative proportional of the variable costs and the fixed costs of the organization.
This analysis allows the manager to know the level of the business operating leverage for informed decision making. The operating leverage is the measurement of the net operational income sensitivity of the specific changing sales. In addition, the analysis also helps the manager to know the sale mix if the company is selling many products with different contribution margins. Any change of the sales mix could cause changes of business profits. This makes the break-even point to depend on the sale mix.
Variable cost, fixed cost and sales Volume in relation to the net operating income
The cost, volume and profit analysis determines the variations of costs and sales volume and the effects of the company operational income. For this analysis to take place, the manager has to maintain that, the selling price remains constant, the varying costs to be constant, the fixed costs to be constant and every product must be sold. In an operating company, costs do change because of the changing business activities. During planning and budgeting of the company’s profits, the manager should be aware of the breakeven point and the safety margin for him/her to make informed business decisions.
The company manager should take into account of the marginal cost of the sales volume, and the fixed cost which always remains the same in a given time irrespective of the business activity level at that period. Generally, for a company to gain profits for a specific period, it requires to cover all the fixed costs in the first place (Kinney, 2008). Basically in business, marginal costs are directly proportional to the company output though fixed costs remains unchanged irrespective of the output volume. A change in net income is affected when; the sale volume changes causing the variable costs to change. Since the sale price and fixed costs remains constant the profit level will definitely change.
The goal of a manager is to strive in relating all these marginal costs elements for the company to attain the maximum profit. The company manager projects the business profits for a given point of time and always uses the cost, volume and profit analysis in decision making especially in the business short run period (Kinney, 2008). An organization manager is always aware of the business profit which mainly depends on various factors including the production costs and sales volume. The two factors depend on each other. The volume of sales generally is dependent to production volume, the marketing forces and the costs. Though the management has no power to control the market, it puts efforts in company costs controlling especially the variable costs since fixed costs remains constant.
Essentially, costs of an operating organization are always based on various factors such as: the production size, the product mix, efficiency of the company, techniques of production and the scope of the company (Globusz Publishing, 2011). This analysis provides a complete structure of the company profits. This allows the manager to differentiate the selling effects, variation of volume and the resulting change in prices of the company products and services.
Generally, for the manager to project accurate profits, he/she ascertain a clear relation between profit, cost and volume. The analysis has been helping managers in planning adjustable budgets indicating the cost in several levels of business activities. It also helps the managers to evaluate the business performance for controlling purposes. The analysis could also help the manager to formulate price policies through prediction of difference in price structures on profit and cost.
Margin of safety basically occurs when a company tries to find out how much the company has exceeded with, to the break even point. It is the difference between the breakeven sale and the sales of a given business activity. If the margin of safety is said to be large, there is an indication of company finance strength and sound (Globusz Publishing, 2011). Margin of safety could be improved through reduction of variable and fixed costs, accumulating more sales, raising the prices and changing the product mix for the improvement of the contribution.
Examples of variable costs, fixed cost and sales volume changes
The cost, volume and profit analysis is the main key which enables the company manager to make informed decisions; it has various impacts on the business profit as demonstrated by the following examples:
- Contribution margin is the amount of sales required to cover the fixed cost and generate profit. So, if Company A had the following income statement and Margin contribution = sale price – the variable cost per unit:
Less variable costs 500,000 = Contribution margin 1,500,000
Less fixed costs 500,000 = profit from the operations 1,000,000.
This shows that the manager will predict for one million profits from the operation.
- Unit contribution margin is the possible profits from the projected projects. For instance, Company A, the selling unit price is $10 and the variable unit cost is $5 the unit contribution margin will be $5 ($10 -$5). Here, the manager had projected for$5 profits as this will help him/her to know what to increase or reduce in the company.
- Breakeven point a point at which there is no profits, all sales and expense are equal.
Breakeven point = Fixed cost/unit selling price- variable unit cost or over contribution per unit:
- Sale price per unit 10
- Whole fixed cost 990
- Varying cost per unit 0.1
- Number of units 100
- Breakeven point =100/ (10*100)-(0.1*100) = 1
In any operating business organization, the manager must make accurate decisions with a target of maximizing the company profits. He/she should understand the cost, volume and profit analysis for him to make informed decisions and proposing the best projects. Though managers always do not have the power to control the market forces, being aware of them will help in deciding the preferred projects catering for those forces. They should understand costs such as Margin of contribution, the breakeven point, Margin of safety, operating leverage as this will be useful in their decisional making. Managers should be conscious of total varying costs, such as direct labor, direct expenses and all the uncontrollable fixed costs. When the contribution level is low, this shows the weakness of the company and when it is high the business is very strong.
In an operating company, there must be various costs involved such as variable costs which include: direct labor, direct expense and fixed costs such raw materials costs. Variable costs are always directly proportional to the output of the company. For instance, when the company production increases, the variable costs such direct labor will automatically increase and fixed costs always remains constant irrespective of the level of the business activity. During decisional making, managers should consider all the business costs such as Margin of contribution, Margin of safety, breakeven point and others for him/her to make the accurate decision. Basically, managers should consider all the costs identified during the cost, volume and profit analysis in order to run an organization well.
Arsham, H. (2007). Break-Even Analysis and Forecasting. Ubalt. Web.
Drury, C. (2007). Management and Cost Accounting. New York: Cengage Learning.
FAO. (2006). Information for decision making. FAO. Web.
Globusz Publishing. (2011). Marginal Costing and Absorption Costing. Globusz. Web.
Hansen, D. R. (2007). Cost Management: accounting and control. New York: Cengage Learning.
Kinney, M. R. (2008). Cost Accounting: Foundations and Evolutions. New York: Cengage Learning.
Weygandt, J. J. (2009). Managerial Accounting: Tools for Business Decision Making. New York: John Wiley and Sons.