Variable costs

Overview and perspective
Variable costs and Costs are important to economies because
process design: of their profound effect on the standard of
critical issues for living. In a world faced with increased
competition, decisions that determine long
``restructuring'' term costs and the management of costs are
emerging and essential to providing for a viable economy.
In restructuring within the EU, in countries
transition economies that compete with the EU, in ``transition,''
and in ``emerging'' economies, decisions
John C. Groth made today that influence underlying cost
structures will have far reaching and long
Steven S. Byers and
lasting implications.
Garland D. Simmons The right perspectives and guidelines on
certain types of costs are important to policy
The authors makers and managers. ``Restructuring'', and
repositioning within and across economies in
John C. Groth is Professor of Finance, College of
the EU, bordering, and competing trade
Business Administration, Texas A&M University, Texas,
partner economies will influence the
USA.
underlying economics of the future of these
Steven S. Byers is Assistant Professor of Finance, Idaho
economies.
State University, Pocatello, Idaho, USA.
The challenge and struggle to integrate
Garland D. Simmons is Assistant Professor of Finance,
European economies and trade will benefit ±
Stephen F. Austin State University, Nacogdoches, Texas,
or suffer ± from decisions that affect the long
USA.
term cost structure of the production
functions of restructuring, emerging, and
Keywords
transition economies. Indeed, in some sense
Variable costs, Process design, Economy the EU itself is a transition economy. How
well individual as well as unions of economies
Abstract will fare in a competitive environment ± and
the resultant standard of living ± will hinge to
Focuses on critical issues related to variable cost drivers
a great part on the sound application of
essential in establishing criteria or parameters to consider
in the modification and/or design of production facilities.
practical economics.
Key concepts and relationships influence the choice of
The interface of the production function
alternative technologies and methods in the design,
with the market for goods and services is
upgrading, modification, or expansion of manufacturing
critical to supporting an economy that uses
and process facilities. Cost relationships are important in
resources to fulfil human needs. Cost
evaluating whether to retain an existing facility or, relationships and management in the
alternatively, scrap the assets and ``start over''. For production function are critical for the
brevity, focus is restriced to decisions concerning survival of an economy in a competitive
overhaul, modification, upgrade, expansion, environment. Emerging and transition
abandonment, and fresh investment as ``design''. economies (E&TEs) face daunting tasks
related to the use of resources to provide need
fulfilment for people. Emerging and transition
Electronic access
economies have the challenge of using limited
The current issue and full text archive of this journal is resources wisely and developing economies
available at that can compete in a regional and global
http://www.emerald-library.com environment.

The focus

This paper offers managerial perspectives
European Business Review
Volume 12 . Number 6 . 2000 . pp. 344±354 on critical concepts, issues, and guidelines
# MCB University Press . ISSN 0955-534X for application of import to managers,
344

Critical issues for ``restructuring'' emerging and transition economies European Business Review
John C. Groth, Steven S. Byers and Garland D. Simmons Volume 12 . Number 6 . 2000 . 344±354

analysts, and decision makers tasked ratio, a factor of great importance if a business
with the challenge of improving the is trying to grow in an economy having high
competitiveness of their organization and, cost and limited availability of capital. In
in turn, their host economy. The authors E&TEs, costs also have considerable effect
also illustrate the concepts and application on inflation and the cost of living enjoyed
with examples. or endured by the people. Consequently,
This paper first provides a review of variable costs, process design and factors
important cost concepts, cost behavior, and relating markets to the production process are
economic relationships. Next, it portrays a crucial in new construction, in modification,
decomposition of ``variable costs'' into
in ``restructuring'', and in other changes in the
contributing variable cost components. Then
operations of existing facilities[2].
it provides a general prescription for
examining, in terms of process design, the
Transition economies (TEs)
intended production function. A discussion
TEs often face a greater challenge in
follows of other issues important in the
competing than do emerging economies. TEs
context of expected market conditions and
frequently have archaic plant, equipment, and
competitors' actions. The decision and design
practices (``plant'') in place with attendant
process must reflect the implications of
expected production, market, and financial costs that limit their ability to compete with
factors as well as possible variance in the developed economies. Intriguingly, TEs may
expected price-demand relationship for enjoy certain advantages: existing productive
product. Next, attention centers on criteria capacity is so inefficient that decision makers
for a strategy that incorporate variable cost may engage in major overhauls or even
considerations in process design. The paper discard the plant and replace it with a new
closes with a summary. one. Whatever the form of the transition,
knowledge of essential relationships to guide
decisions and change will have great impact
Background perspectives on the future ability of TEs to generate value
for the benefit of production agents as well as
Relationships between costs in the production the populace.
function and the markets for goods and
services are particularly important in E&TEs. Emerging economies
Success in providing for an efficient Emerging economies often lack sunk
production and distribution scheme in terms investment in plant and equipment and face a
of the fulfilment of the population's needs is different, but at least equally important,
integral to creating economic value for society challenge: managers must make informed
and production agents. decisions to allow for optimal use of limited
Factors pertaining to production and capital in order to provide for productive
distribution costs have a great impact on the
capacity that is competitive in competitive
creation of value and the development of an
markets. Managers in emerging economies
economy. Costs and economic relationships
will benefit from understanding important
are important in all economies. Favorably
cost relationships as they relate to process
altering cost relationships yields a non-linear
design and markets.
positive impact on value[1]. Similarly,
adverse cost relationships have a disastrous
Restructuring economies
effect on value.
EU and bordering countries will face the
Emerging and transition economies competitive forces that stem in great part
E&TEs characteristically lack sufficient from the underlying cost structures of
capital and have high capital costs. competing economies. The continued trend
Consequently, costs and attendant in global competition adds import to
managerial decisions have a disproportionate decisions that affect the future cost structures
impact on success or failure in E&TEs. of production and distribution within the EU.
Certain costs and relationships Hence, the principles that guide decisions
are critical in E&TEs. For example, a about future cost structure are of paramount
reduction in costs reduces the capital intensity importance to the EU.
345


Costs, production and markets Contribution margin (CM)
Reviewing some terms and relationships will
Variable costs and markets
support the introduction of an important and
Components of variable costs and the
powerful concept: contribution margin (CM).
behavior of these variable costs are crucial
CM and the relation of variable costs to CM
factors in process design. Decisions in process
are critical in design considerations and
design also depend on the relationships
managerial decision making. Contribution
between market demand, level of production,
margin equals revenue less the variable costs
and variable costs. The tie-in between the
incurred to allow one to realize the revenue.
markets for goods and services and the
CM is the ``leftover'' after covering VC. CM
productive process is an essential relationship
only ``happens'' if activity occurs:
that did not play a major role in former
planned economies. CM ˆ Revenue À Variable Costs
In a fiercely competitive environment,
Positive CM is available to cover or eat up
overlooking these issues may lead to a
fixed costs. If one generates just enough CM
disastrous economic outcome. On the other
to cover FC, the operation is at ``break-even''
hand, incorporating these elements in
(BE).
decision making during process design, as
Negative CM uses up capital. If variable
well as in operations, will lead to competitive
costs are greater than revenues, sales and
advantage.
associated production activity deplete capital.
Variable costs associated with the
Having negative contribution margin is akin
manufacturing or processing of products are
to bleeding to death. The loss for the period is
key factors that determine the economic
the uncovered fixed costs (none covered since
profitability of an operation. In addition, the
CM is negative) plus the negative CM.
relationship of variable costs to a firm's
revenues, control of costs, and the variable
costs of competitors, affects the risk of the Confounding factors
firm, capital employed, and the cost of Competitive dynamic markets normally result
capital. The interplay of risk, return, capital in interplay between price and the volume of
employed and capital costs determines the demand for a product. Volume produced
creation or destruction of economic value. usually influences the variable costs of
production. Consequently, criteria for process
Relating production to markets design, facility choice, and operation of the
Economic value creation stems from the resultant facility are sensitive to managerial
fulfilment of needs for customers in the decision making in the context of the pricing-
markets for goods and services. Those sales-production and attendant variable costs.
charged with using assets and resources wisely In process design, aggregate contribution
to create value should understand the margin drives the economic decision.
relationship between markets and the
production function. In particular, they need
to recognize the true origin of value creation. Aggregate contribution margin
Decisions about productive assets and Commonly one characterizes contribution
investments in and disinvestments from margin on a per unit basis or as CM per dollar
productive assets must take into account the of sales. In addition, one should focus
vital market-dependent variables and the attention on the aggregate contribution
effects of seasonal and cyclical changes in margin (ACM) generated over the time frame
demand on price-sales relationships. of interest given market conditions:
ACM = sum of contribution margin for the
period
Background: financial economics = Sum of the units sold with a given
contribution margin times the
Appendix 1 reviews aspects of managerial volume at that margin. Since
accounting useful to the reader who has not production rates, variable costs,
studied or worked in the field in recent years. and sales price may vary om tje
A quick review will support the discussions period, the ACM is the sum of the
that follow. increments of generated CM
346


Appendix 2 provides illustrations of the above for a product. Notice the low point in
points. Scrutiny of the examples for each aggregate variable costs is 3,300 tons per day.
quarter (Q) in Appendix 3 leads us to the The characteristics of the ``curve'' stem
following summary points especially from a variety of factors including:
important in markets in which demand varies . The ``natural'' phenomena captured in
in response to price: the underlying process(es). Factors such
. Compare Q1, Q2. The VC is lower for Q2 as effectiveness of a catalyst, time since
and the CM is naturally higher, $40,500 last catalyst charge, different levels of flow
vs $36,000 for Q1. activity and the non-linear nature of heat
. Compare Q2, Q3. In Q3 production/sales transfer cause non-linearity in some
are lower but price is higher. Although operations.
one would expect the VC to change as . The design of the process.
production and sales change, we have . The ``operation'' of the process.
kept the VC the same in both quarters to
. Changes in costs of input that vary with
focus on the effects of price versus volume volume of operations. If choice of process
sold and ACM. Raising the price results affects the variability of input costs, this
in fewer units sold, lower dollars of sales, point is relevant in this discussion.
but higher ACM for the quarter even
. Extant operating factors of influence. For
though VC is the same for Q2 and Q3. example, ambient temperature will affect
We recognize that we do not always variable cost behavior in some processes.
produce at the lowest variable cost point The nature, shape, minimum point,
nor should we set price to maximize sales. relationship of the minimum to operating
. Compare Q3, Q4. The lower VC increases capacity, product price-demand relationships
ACM, lowers break-even, and increases and a host of other factors affect the economic
the sensitivity of profits to a change in profits of the firm, invested capital, risk, and
production. consequently creation of value.
. Changing from original to scenario 1, to
scenario 2 results in lower total sales but Dis-aggregate variable costs
higher aggregate contribution margin. Frequently, individual ``process points''
Importantly, the break-even point for during manufacturing generate variable costs.
scenario 1 is lower and again drops when Table I provides the variable costs-volume
shifting to scenario 2. A lower break-even relationships for the different production
results in lower operating risk. Aside from process points. Note the minimum variable
the added value of more economic cost at each process point occurs at a different
contribution margin, the lower risk results volume of production. For cost #3, the
in an addition to value. minimum may be at a level of production
. Lowering the variable costs also results in a greater than 3,700 tons per day. Shortly, we
reduction of capital at risk in the working will return to discuss these individual costs.
cycle and the need for and costs of
external financing[3]. Another increment
is then added to value. Economic decisions

Normally, product price affects product
demand. Consequently, one might not always
Aggregate vs component variable costs
produce at a rate resulting in production at
Aggregate variable costs the minimum point on the variable costs
Characteristically, many have thought in curve. Given a plant in place and existing
terms of ``the'' variable cost per unit market conditions, one is not trying to
produced. Managers also often examine the minimize costs. Do not misinterpret this
relationship between variable cost per unit statement. Given product price and resultant
and volume or activity. Table I illustrates an demand and a level of production, we should
example of a project with five process points minimize costs. However, the price-
and attendant variable costs for each process production decision rests on understanding
point. The rightmost column of Table I market conditions, the interplay of price
provides variable costs vs production volume versus demand, and the relationship of VC to
347


Table I Total variable vs individual variable costs as volume changes
Volume per day Cost 1 Cost 2 Cost 3 Cost 4 Cost 5 Total var. costs
2,300 23.52 51.61 18.34 9.87 18.05 121.39
2,400 23.28 50.84 18.16 9.67 18.03 119.98
2,500 23.05 50.06 17.79 9.38 18.01 118.29
2,600 22.82 48.82 17.47 9.28 17.96 116.35
2,700 22.47 47.36 17.33 9.25 17.88 114.29
2,800 22.14 45.94 17.16 9.22 17.72 112.18
2,900 21.81 44.11 16.83 9.28 17.53 109.56
3,000 21.37 44.54 16.49 9.37 17.31 109.08
3,100 20.95 45.43 16.13 9.48 17.03 109.02
3,200 20.53 46.11 15.81 9.64 16.68 108.77
3,300 19.91 47.26 15.49 9.79 16.29 108.74
3,400 20.11 48.45 15.44 9.95 15.76 109.71
3,500 20.37 49.66 15.42 10.17 15.82 111.43
3,600 20.77 51.25 15.41 10.32 15.91 113.66
Note: Figures in bold represent low points in the variable cost curve for the variable costs at the different process
points 1-5

production rates. We seek to precipitate a sure production would take place within the
decision that maximizes aggregate range B*, we would strive for the curve B
contribution margin (ACM) once fixed costs relationships in design. We might also design
exist. for B if we can produce and store the product
Pricing, the effects of pricing on demand, and ± and the risk and economics of the produce
the variable costs given production levels and store strategy dominate production under
interact to yield the aggregate contribution curve A relationships. We might also design
margin. Process designers should take into for curve B if we can contract the taking of
account the expected relationships of market- output within the B* range of production.
production-cost factors expected to prevail Alternatively, if demand-production is quite
and design the process to allow generation of variable or unpredictable due to seasonal,
the greatest contribution margin. cyclical or other factors, economic decisions
Figure 1 depicts two variable costs curves. in a risk-return context might prompt us to
Curve A is shallow but over some ranges of design for curve A.
expected demand-production does not Given the choices of A, B and C, we should
achieve variable costs as low as in certain sell 9,000 units at $6.00 even though dollars
ranges of curve B. If we were reasonably of sales and variable costs per unit are lower at

Figure 1 Variable costs/unit vs production

348


production of 10,000 units (see Table II). Table IV
Also, notice in Table III for AA, BB, and CC Product and Aggregate
the effects of shifting the low variable costs price ($) Volume sold CM/unit ($) CM ($)
per unit to different levels of production and
sale. If price-demand market conditions result D 9.00 6,000 9.00 ± 4.75 = 4.25 25,500
D 8.25 8,500 8.25 ± 5.00 = 3.25 27,625
in only the choices of A, B and C, ideally the
minimum point in the VC curve would be at a Shifting the entire VCnow curve down by 0.25 to VCnew would result in
volume of 9,000 units. DD 9.00 6,000 9.00 ± 4.50 = 4.50 27,000
BB results in an improvement in CM of DD 8.25 8,500 8.25 ± 4.75 = 3.50 29,750
$36,000 ± $34,650 = +$1,350.
Altering the shape of the curve so the low point is at 8,500 units
To the extent the design can influence the
DA 9.00 6,000 9.00 ± 4.90 = 4.10 24,600
location of the low point in the VC,
DA 8.25 8,500 8.25 ± 4.50 = 3.75 31,875
incorporating expected market conditions in
the design process is important.
the potentially adverse impact of a
Another alternative offers even greater
pronounced, rather than a shallow, variable
economic bliss: the situation shown below for
cost curve.
product D. Under these circumstances the
process design and attendant level of
operation might shift the VC curve lower
and also move the minimum cost point on the Economic relationships and design
curve to the demanded volume. Consider implications
product D with two possible price-demand
Note in Table I the current total VC is
scenarios and a current variable cost per unit
minimized at $108.74 at a production level of
curve, VCnow (Table IV).
3,300 tons per day. To focus on the design
Obviously, lowering the variable cost curve
issue relative to components of VC, suppose
while preserving its shape is always beneficial
this company expects price-demand of 3,200
as DD reveals. Notice for DA at $9.00 the VC
tons per day, 250 days per year. Assume
has gone up to $4.90. The rise in VC was the
through design one achieves the current low
price we paid to lower the curve at the
point in VC for each process at 3,200 tons per
expected optimal price-demand point. The
day:
benefits of changing the shape of the curve
and its low point depend on the price-demand gurrent Aggregate VC ˆ $108X77
relationships that materialize. The risk
associated with the generation of contribution xew Aggregate VC ˆ $104X41 …19X91
margin is a function of the price-demand- ‡ 44X11 ‡ 15X41
production-VC relationship. The greater the ‡ 9X22 ‡ 15X76†
uncertainty in production level, the greater
Since the sales price is independent of this
Table II change, the change in aggregate contribution
Product and Aggregate margin is:
price ($) Volume sold CM/unit ($) CM ($) Difference: $108.77 - $104.41
= $4.36 per ton
A 6.10 8,000 6.10 ± 2.40 = 3.70 29,600
B 6.00 9,000 6.00 ± 2.15 = 3.85 34,650
Per day: $4.36 Â 3,200
C 5.35 10,000 5.35 ± 2.00 = 3.35 33,500
= $13,952
Per year: $13,952 Â 50 weeks Â 5 days
Notes: Assume VC/unit = $4.00. No inventory held.
Production = sales. Includes units of demand at various prices = $3,488,000
Over the life of the plant, this increment to
economic profits offers a potentially attractive
Table III present value. To the extent inflation has an
Product and Aggregate
impact on costs equally in terms of old design
price ($) Volume sold CM/unit ($) CM ($)
versus new design, the benefits are greater
since the inflation effect will compound from
AA 6.10 8,000 6.10 ± 2.00 = 4.10 32,800
a lower original cost base.
BB 6.00 9,000 6.00 ± 2.00 = 4.00 36,000
Naturally, one needs to analyze the costs of
CC 5.35 10,000 5.35 ± 2.00 = 3.35 33,500
effecting the shifts in the minimum points for
349


component costs in terms of these benefits as Guidelines for process design
well as other issues, such as how shifting Guidelines for analysis include:
individual process point minimums affects . Identify the potential cost of independent sub-
the shape of the aggregate VC curve. For units or ``process points'' in the
example, in terms of making a risk-return production process.
decision, great uncertainty in demand may . Examine the underlying physical
favor a shallow curve that is ``not as low''. relationships that determine the
Alternatively, greater comfort in predicting characteristics of each process point.
demand may allow operation at a lower point . Determine the controllable variables for each
but require giving up a shallow curve. process point and the effects on variable
In some situations production costs of changing the levels of those
arrangements allow improvement in variables.
contribution margin rather than actually . Assess whether variables at one process point
changing the individual processes. For influence the behavior at another process
example, it may be ``cheaper'' in terms of point. If such influences of joint effects
design and construction or in the operation of exist, one must estimate the joint effect
an existing plant to operate the different variable cost versus throughput for the
process points at different speeds ± operating points.
each process at its low point on the variable . Estimate the effects of seasonal and cyclical
cost curve ± and storing output until needed demand on the expected production range.
as input for the next process. Although we . Determine the feasibility of several smaller
relegate details of such schemes to another production units as opposed to one large
paper, the notion is important in process production facility. Consider the trade-offs
design for several reasons including: between economies of scale vs the flexibility
. the design process might incorporate this of several smaller units. In examining the
flexibility to allow minimizing variable one large production unit option, the shape
costs either in ``fine tuning'' during of the aggregate VC curve is especially
normal production or in response to important if predicting demand is difficult,
demand-volume changes due to seasonal or if a great variance in demand exists due
and cyclical factors; to seasonal and cyclical factors.
. physical realities or costs of design and . Evaluate the possibility of shifting the low
construction may inhibit or preclude points in variable cost curves as well as the
attaining the ideal variable costs to possibility of lowering the entire curve(s).
volume relationship at one or more of the . Consider production scheduling alternatives
process points; and with respect to individual process points as
. the process may allow for lower aggregate well as seasonal demand. Example:
variable costs over a wider range of suppose the variable costs-to-sales ratio will
production. economically allow the carrying of partially
Aside from the physical feasibility of varying or fully completed units in inventory, and
process speeds and affects on variable costs, the product does not deteriorate and is not
analysis of such flexible manufacturing must subject to an unacceptable risk of
incorporate other factors such as the obsolescence. Under these circumstances it
economic costs of idle capital captured in may be attractive to produce and hold for
work in process waiting for the next stage of sale rather than incur possible incremental
production. expenses of an alternate design.
. Non-continuous process. If one can ``store''
the output of a process point and later
Issues in process design feed the successive process point, it may
be wise to produce a process point at the
Process design should consider the expected optimum volume in terms of having the
interplay of price-demand-production as well minimal process point variable cost per
as a host of other factors. This prompts the unit. For example, for process point
need for general guidelines for considering YYY, operate it at level YYY and allow
variable costs behavior in process design and for idle time. In addition, consider other
facilities choice. cost/benefit considerations in the analysis.
350


Important issues: production-market inventory buildup might not be beneficial
factors for changes in demand due to economic
Consider the following factors individually cycles.
or in combination, depending on the . Inside vs outside capacity. A host of factors
circumstances: warrants consideration. Example: it may
. Predictability of market price-demand. A be better to produce at smaller volume
high variance in expected volume might and buy in outside units. A second
argue for a VC curve that is ``shallow'' example: examination of industry
over a reasonable range of expected capacity relative to position in the
production (curve A in Figure 1) even if economic cycle might support designing a
this means foregoing the opportunity to plant allowing positive margins during a
have a lower VC at a particular level of recession with dependence on ``buying
production (curve B in Figure 1). in'' additional needs and/or using pricing
. Wide swing in demands, e.g. over a business strategy to optimize contribution margin
cycle. Demand-production-variable costs during boom times.
analysis suggests examining the merits of
``multiple units of plant'' or ``lumpy
capacity''. The ability to adjust capacity General criteria for action
by adding or taking off the line a unit of
capacity may allow variable costs You may be responsible for designing a
advantage considering the full cycle of process or in specifying and making decisions
potential demand. Decisions about concerning changes and/or additions to the
designing a process with multiple units of process that provides goods or services for
production hinge on a host of factors customers. Consideration of the following will
including: variable costs in total as assist one in developing a strategy for process
volume changes over some period of design and in managing the resulting process
time; the ability to operate only some of to maximize the generation of economic
the units of production during low contribution margin:
demand and still have positive cash . Ensure that each person in the planning
margin; the possibility that during periods and decision process understands the
of high demand, variable costs might nature of variable costs and contribution
exceed those possible with a larger ``single margin.
plant'' enjoying economies of scale and . Consider the total dollars of fixed costs
lower variable costs. For example, the associated with choices[4]. In economic
ability to survive during a recession might decision making, ignore the allocation of
be favored over lower variable costs that fixed costs.
are only realized during normal . Make sure each person involved in the
production volumes and production rates design and decision process understands
during a down turn in the cycle. the interplay between potential market
. Unpredictable industry capacity. The conditions-pricing-demand-variable costs
multiple units approach above may offer a of production.
better alternative in terms of risk . Develop scenarios for changes in price-
management since one can take a unit on demand attributable to seasonal and
or off line. cyclical factors.
. Near certain demand or contractual demand . Assess the current and potential capacity
for a customer to take products at a within the industry as well as other
particular volume suggests designing the developments that may affect the
process to obtain the lower VC in the industry.
vicinity of that volume. . Decide on acceptable production costs
. Seasonal cyclical demand issues. Variance in during periods of low demand and the
demand attributable to seasonal and company's strategy during low demand
cyclical influence on strategy and periods. For example, analyze if the
resultant design process occurs in several company should operate on small positive
ways. A company may choose to meet or even negative margins for periods.
seasonal demand by early production and . Decide on the strategy the company will
buildup of inventories. However, early take with respect to the market. The
351


production process must be sensitive, emerging economies invest capital into new
responsive, and consistent with the equipment and technologies, both economies
company's strategy to harvest value from benefit disproportionately when firms
customers. properly incorporate variable cost
. Given the above, set design objectives relationships and get the process right.
and constraints.
. Identify and evaluate different alternative
processes and methods suitable for Notes
producing the product or service to satisfy
customer demand. 1 A discussion of this non-linear relationship is
. Evaluate the relative merits of the process included in Groth, J.C. and Kinney, M.R., ``Cost
choice. Select the optimal process. management and value creation'', Management
Decision, Vol. 32 No. 4, 1994, pp. 52-7.
. In design, seek to minimize the variable
2 A separate paper addresses operating issues and
costs of production at individual process cost management for an existing production facility.
points as well as the aggregate variable 3 For a discussion of these issues please see
cost given anticipated price-demand- Groth, J.C., ``The operating cycle: risk, return, and
production relationships. opportunities'', Management Decision, Vol. 30
No. 4, 1992, pp. 3-11.
4 Critical factors related to fixed costs are the subject
of a forthcoming paper.
Summary

The creation of value is sensitive to both the
generation of economic benefits and the Appendix 1. Aspects of accounting
perceived risk of those benefits.
The practising manager and decision maker
Consequently, one must consider the effects
who has not studied or worked in the finance
of process design on variable costs, break-
or accounting field in recent years will find
even, and the ability to generate attractive
this review helpful.
contribution margins in an unpredictable
Fixed costs (FC). Fixed costs are those costs
market. An understanding of basic cost
that will not vary in a period as a result of
relationships and contribution margin
changes in level of operations. Design does
provides the basis for making decisions
affect the fixed costs associated with an
regarding the design of new, as well as
operation. Fixed costs are critical in the risk-
modification of existing, production facilities.
return-value context. Usually trade-offs exist
The effects of variable costs on economic
contribution margin prompts diligent between fixed costs and other costs. Fixed
attention to variable cost relationships in costs are not always invariant over the
process design. It is crucial that designers potential range of operations. Sometimes
and decision makers take account of the fixed costs step up or down as operations vary
interplay between markets and production beyond a certain level. The dollars of fixed
and the separate variable costs that sum to costs that the company actually must pay in a
the variable costs at a given volume of period are very important.
operations. Allocated fixed costs. For certain reasons ±
The paper also provides guidelines useful in some logical and related to ``matching'' costs
developing a perspective to support logical over time ± accountants ``allocate'' fixed costs.
decisions as we strive to create value in an We focus on economics, not accounting. In
uncertain marketplace. Focusing on variable some instances, what is relevant for
costs and contribution margin in process accounting is not relevant in economic
design is critical in the endeavor to generate analysis and decision making. Remember, the
value in a risk-return environment. total dollars of fixed costs are very important
The paper discusses issues and guidelines of and relevant in decision making and design.
particular importance to economies that lack In contrast, allocated fixed costs are not
sufficient capital. Scarcity and high cost of relevant in economic decision making. One
capital makes the efficient investment of must take particular care not to make
available capital even more critical. As economic decisions based on what frequently
transition economies seek to overcome their is called ``gross margin'', reflecting a margin
installed base of inefficient assets and as after allocated fixed costs.
352


Variable costs (VC). Variable costs occur Table AI
only because of activity. If making a unit A ($) B ($)
causes a cost, it is a variable cost. Although
Sales price/unit 5.00 5.00
people commonly talk about the variable cost
Variable cost/unit 3.00 2.75
of a unit of product, the variable cost is
Contribution margin/unit 2.00 2.25
usually an aggregate of various components of
Contribution margin/$ sales price
variable costs, e.g., labor, material, energy.
($2.00/$5.00 and $2.25/$5.00) 0.40 0.45
Because of the allocation scheme, the
previously mentioned allocated fixed costs . To break even: 16,000 sold Â $2.00
might appear variable. This appearance might = $32,000 of CM, which is just enough to
result from an allocation method that is cover the FC of $32,000.
sensitive to the level of operations. Whatever . Sell 16,001 units and the CM from the
their appearance, allocated fixed costs are not extra unit above break-even contributes
variable costs and are not relevant in $2.00 to pre-tax profits.
economic analysis. Do not mistakenly . Sell 15,900 units and the company has
consider an allocation that varies as a loss. It only had enough CM to cover
production varies with variable costs. or eat up 15,900 Â $2.00 = $31,800
Accounting revenue. ``Revenue'' (R) is an of the $32,000 of FC. The $200
accounting term. Revenues represent uncovered FC represents a loss for
entitlement earned. Selling goods or services the period.
results in revenues even if we have not
received payment from the customer. Condition B
Collection of the revenue results in a cash The company lowers its VC/unit = $2.75
inflow. In this paper, we will assume revenues and FC remain at $32,000. The new situation
is:
turn into cash flows in the same period.
. To break-even: $32,000/$2.25/unit
The matching principle. The ``matching
= 14,222 units
principle'' causes accountants to expense a . At the old level of break-even 16,000
cost during a period if the cost was essential to
units, with Condition B the pre-tax
the creation of revenue within the same
profits are units above break-even
period. A cost may exist in a period but that Â CM/unit = (16,000 ± 14,222) Â $2.25
cost is not matched with a revenue of the = $4,000.50.
period, and hence is not expensed in the
period. Under these circumstances, the cost
will be expensed in some other period. None-
Appendix 3. Aggregate contribution
the-less, a cost incurred in a period still exists.
margin
Such ``unmatched costs'' remain embedded in
the amount shown on the balance sheet. For
example, costs may be in goods made, not yet Aggregate contribution margin
sold, and appear on the balance sheet as part Company changes pricing strategy at the
of finished goods inventory. beginning of Q3 (Table AII). Notice the
change in sales price and attendant change
in units sold and also the change in variable
Appendix 2. Illustrating key concepts costs.

Assume that plant is in place. Fixed costs for Table AII
the period total $32,000. The company Q1 Q2 Q3 Q4
makes a single product to match sales
Units produced and sold (Â1,000) 18.00 18.00 17.50 17.50
demand. Sales and costs turn into cash flows
Sales ($1,000) 90.00 90.00 89.25 89.25
during the period. Consider conditions A and
Price/unit ($) 5.00 5.00 5.10 5.10
B (see Table AI).
Variable cost/unit ($) 3.00 2.75 2.75 2.70
Contribution margin/unit ($) 2.00 2.25 2.35 2.40
Condition A
Contribution margin/$ sales 0.40a 0.45 0.46 0.47
Each unit sold contributes $2.00 that can eat a
Note: $2.00/$5.00 = 0.40
up the FC:
353


Calculation of ACM for all four quarters given Scenario 2. Alternative
above price-sales-production: price-sales-production-VC
Q1 À 2X00 Â 18Y 000 ˆ 36Y 000 Company produces all year long at Q4 price and
Q2 À 2X25 Â 18Y 000 ˆ 40Y 500 volume, new lower VC. Same units sold as in
Scenario 1:
Q3 À 2X35 Â 17Y 000 ˆ 41Y 125
Q4 À 2X40 Â 17Y 000 ˆ 42Y 000 ACM ˆ …2X40 Â 17Y 500†4 ˆ $168Y 000
ACM ˆ $159Y 625
Important: Scenario 1 and successively
Scenario 1. Alternative Scenario 2 results in lower units and
price-sales-production dollars of sales but higher aggregate
Company produces and sells all year long at Q3 contribution margin and lower operating
price, VC, and sales level. Note, units sold and risk since the break-even points decline.
$ sales are less than for original Q1, Q2, Q3 Aside from the added value of more
and Q4: economic contribution margin, the
ACM ˆ …2X35 Â 17Y 500†4 ˆ $164Y 500 lower risk results in an addition to value.

354

Variable costs

More Related Content

Viewers also liked (9)

Similar to Variable costs (20)

Recently uploaded (20)

Variable costs