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By James A. Brimson and Raghu Santanam
There is agreement in neoclassical economics that, in the short term,
resources display a fixed or variable relationship to activity volume.
Accounting theory and practice base several decision making methodologies on
the fixed and variable hypothesis. Chief among these practices are breakeven
analysis and marginal analysis.
This article discusses the
breakdown in the relevance of fixed and variable cost in economic and
accounting theory. The breakdown has been precipitated by the transition
from a manufacturing to a service-oriented economy and the advent of the era
of near instantaneous information. Both these trends have blurred the
distinction between fixed and variable costs. In its place, the emergence of
process theory and process economics has provided a superior foundation for
managerial decision making.
Fixed and Variable Cost in Neoclassical Economic Theory
Neoclassical economics asserts that the short run activity level
function shows a relationship where all inputs display a variable or fixed
relationship to activity level. A firms total cost (TC) is the sum of all
fixed and variable costs.
TC = TFC + TVC
Where: TC:
Total Cost
TFC: Total Fixed Cost
TVC: Total Variable Cost
Average Unit Cost (UC)
normalizes cost using activity level volume (activity level). Unit cost is
an extremely important concept in understanding economic cost behavior.
UC
= (TFC + TVC) / Q
=
AFC + AVC
Where: UC:
Unit Cost (fixed and variable)
Q:
activity level Quantity (production units)
AFC: Average Fixed Costs
AVC: Average Variable Costs
AFC constantly falls as
output increases. In most cases, AVC will fall and then increase due to
diminishing returns. For many information products and services, AVC may
even be close to zero.
Marginal cost is the change in total cost that occurs when the activity
level quantity is incremented by an additional unit. Marginal cost (MC) is
expressed mathematically as the first derivative of the total cost (TC)
function with respect to activity level quantity (Q).
Marginal cost addresses the question: how much will it cost to produce one
additional unit of output? MC equals
slope of the total cost function and the variable cost function.
MC = slope TC /Q
A key assumption
underpinning marginal cost analysis is that of diminishing marginal returns.
If we add more variable input (s) to fixed inputs, then the average unit
cost will decline. The total cost curve will flatten out as the quantity of
the variable input increases. Therefore, marginal cost may fall initially,
but it must eventually increases but at a decreasing rate.
Fixed and variable theory
is an essential condition of breakeven analysis. A firm will breakeven when
its total sales or revenues equal its total expenses. At the breakeven
point, no profit will have been made, nor have any losses been incurred.
Breakeven point is the lower limit of profit when determining margins.
Breakeven is calculated as follows:
BPf
= TFC / (USP - AVC)
Where: BPf:
breakeven point (fixed and variable defined)
USP:
unit selling price
Fixed and variable defined
breakeven occurs where average total cost equals price at the
profit-maximizing output. If the price is between average total cost and
average variable cost at the profit-maximizing output, then the firm is said
to be in a loss-minimizing condition. The firm should still continue to
produce, however, since its loss would be larger if it were to stop
producing. By continuing activity level, the firm can offset its variable
cost and at least part of its fixed cost, but by stopping completely it
would lose the entirety of its fixed cost.
If the price is below
average variable cost at the profit-maximizing output, the firm should go
into shutdown. Losses are minimized by not producing at all, since any
activity level would not generate returns significant enough to offset any
fixed cost and part of the variable cost. By not producing, the firm loses
only its fixed cost. By losing this fixed cost the company faces a
challenge. It must either exit the market or remain in the market and risk a
complete loss.
Fixed
and Variable Assumptions
There are a multitude of
assumptions that underlie fixed and variable analysis. The fixed and
variable distinction depends on:
- The resource
cost behavior pattern. The consumption pattern for any resources
is either fixed or variable to changes in the level of activity. For
example, direct material, direct labor, sales commissions, equipment
related electricity and so on, are considered a variable cost and are
expected to increase with each additional unit of output.
Note: Any given resource might be considered fixed or variable depending on
how it is consumed relative to a given level of activity. The important
distinction is that the fixed and variable distinction is attributable to
the type of resource.
Resource characteristic
(fixed, variable)
- The analysis
time horizon. The analysis period influences whether a cost is
fixed or variable. Fixed costs pertain to the short run. It is difficult
to alter capacity in the short term. In the long run, all costs are
variable.
- The level of
activity. Fixed costs are constant in total and variable costs
are constant per unit of output. The activity volume (workload) is the
factor that causes the incurrence of a variable cost.
- Labor is a
more flexible resource than capital investments.
People can perform multiple tasks flexibly, while capital investments,
such as acquiring machinery, is most often designed for a specific use.
If a capital investment isn't used for its intended purpose, it has
limited capability to be used for alternative purposes. Thus, capital
investment is a greater fixed commitment than hiring a person.
Fixed
and Variable Assumption
Challenges
There have been challenges
to the fixed and variable assumptions in the past. The most common
challenges include:
1.
All costs can be
classified as fixed or variables.
There are many costs in an
organization that display a multitude of cost behavior patterns depending on
the context in which the resource is used. Consequently, splitting out fixed
and variable costs depends on the assumptions made by the analyst.
2.
There are a multitude of factors
that impact cost behavior other than activity level volume.
A few of the more significant factors that cause changes in total cost or a
cost per unit other than activity volume include the following:
i.
Economies of and diseconomies of
scale. Economies of scale increase activity efficiency as the number
of goods being produced increases. Typically, a firm that achieves economies
of scale will have lower average cost per unit over an increased number of
goods without a corresponding change in activity level volume. Thus,
variable costs are in essence variable but not absolutely variable.
Diseconomies of scale are the opposite. Diseconomies occur when increased
activity levels drive up unit costs due primarily to resource constraints.
Resource constraints lead to bottlenecks. Diseconomies of scale cause
inefficiencies within the firm and result in rising average costs
ii.
Relevant range. A
relevant range is the upper and lower levels of activity within which
the firm expects to operate within the short-term planning horizon. The
business activity level provides a foundation upon which to base cost
behavior assumptions. It is risky to extrapolate beyond the relevant
range because there has been no analysis outside the range to base cost
behavior. Beyond the relevant range, fixed costs are not necessarily
constant.
iii. Tariffs and directed taxes. Tariffs and directed taxes change resource
cost behavior. A firm can experience rising costs without a change in
activity level.
iv.
Trade discounts. Trade discounts
will lower the cost of resources without a change in activity level.
v.
Inflation/deflation. Resource
price level changes impact cost behavior.
vi.
Currency exchange rates. A
constantly changing international currency exchange rate effects unit cost.
vii. Resource efficiency. Unit costs will
decrease when a process is improved. Likewise, unit costs creep up when
management attention is diverted from continuous improvement. The learning
curve effect directly impacts efficiency.
3.
Units are constant.
Activity level is expressed in units of sales and activity level.
Determining a homogeneous sales unit is problematical.
i. Activity level (production volume).
Most firms offer a portfolio of products resulting in a mix of potentially
extremely different units.
ii.
Unit selling price. Unit selling
prices typically are not uniform across customers. A discount for a large
quantity purchased is a common practice.
Assessing the fixed and
variable cost split can be fraught with difficulties and can be time
consuming. The best that can be said for splitting costs into fixed and
variable attributes is that it is complicated! Complexity leads to uneven
application of the theory. Uneven application of theory diminishes its
relevance.
Process
Economics
The inconsistency of fixed
and variable classification is due to its emphasis on the prime driver of
cost behavior to be the resource type. The type of resource is situational
dependant and cannot be relied upon to be a consistent measure of economic
behavior. Associating cost changes to volume changes is problematical.
Employing a process foundation to understand economic behavior can instead
provide a better decision rationale for managers.
Process economics
hypothesizes that a firm provides its products and services through a
network of processes. Each process performs its role in the product and
service delivery system. Firms design each process to function using process
transformation logic and then assigns resources in accordance with the
transformation logic. The process selection and allocation of resources to
processes determines the firms capabilities and capacity to perform its
function.
Process logic more closely
mirrors the business and natural world than neoclassical distinction of
fixed and variable. Processes better explain change and the intermediary
results that follow. Let us follow the process view of the world.
- An organization
establishes processes to achieve a desired outcome. The intrinsic
processes are necessary to provide a desired capability.
- An organization
assigns resources to its processes based on the process transformation
logic. The magnitude of resources assigned to a process governs process
capacity.
- The first priority of
a process is to achieve its targeted capability (outcome).
- Capable processes next
should strive for improved efficiency (including shedding excess
capacity for example).
A process is inexorably
intertwined with resource consumption. The process transformation logic
dictates how the process transforms an input into an output and how the
resources are consumed in the transformation process. Thus, the type of
resource needed by a process is derived from the process design. The firm
must hire labor with prerequisite skills, acquire and maintain machinery,
provide facilities and information technology. All these resources are
critical to a process being able to function to accomplish a desired
outcome.
Process economics places
the prime driver of cost behavior on the process. All the resources
specified by the transformation logic are bundled together. An individual
resource cannot be isolated from the bundle without potentially changing the
effectiveness of the entire process. Accordingly, all resources are equally
essential to achieving a desired process outcome. The resources, in bundle,
represent the firms commitment to providing capability and capacity.
A theorem of process
economics hypothesizes a cost behavior hierarchy.
Theorem
of process resources. process transformation
logic prescribes the essential resources and how the resources
are consumed in the transformation process.
- Structural
and discretionary corollary: All resources
assigned to process are either structural or discretionary. A structural
resource is integral to the process transformation logic and thus is
essential to the continued effectiveness of the process. A structural
resource is committed to a process for as long of a period as the
resource is embedded in the process transformation logic. The activity
level determines process capacity. A discretionary resource is optional
to the process transformation logic and thus a point in time decision of
whether to incur the cost or not. A process will continue to operate as
before if a discretionary cost is delayed or canceled.
- Resource
capacity corollary:
All resources have a used and unused
component. As a process consumes resources, the unused component is
decreased and the used component increases.
The process model
expresses a firms cost structure as follows:
TC
= TSC + TDC
Where: TC:
total cost
TSC: total structural cost
TDC: total discretionary cost
The minimal cost of
resources assigned to a firms processes represents a structural commitment
of costs. Structural costs behavior patterns are a result of the processes
cost behavior.
TSC
= Sum (PSC)
Where: PSC:
process structural cost
The direct components of
process structural costs include the common natural resources of labor,
machinery, energy, facilities, information technology and consumables.
PSC
= Sum (PL + PM + PE +PF + PIT + PC)
Where: PL:
process labor
PM: process machinery
PE: process energy
PF: process facilities
PIT: process information technology
PC: process consumables
A discretionary cost
is an optional resource that can be provided to a process to enhance its
effectiveness or efficiency. The key element that distinguishes
discretionary from structural costs is the timing of the commitment of cost.
Structural costs are an ongoing commitment of costs by a firm to provide
capability and capacity to provide a product or service. Discretionary costs
represent process enhancements that provide additional capability, capacity
or improve efficiency. The decision when and where to invest in process
enhancements are at the discretion of management. Costs are committed to
process enhancement based on the most current set of conditions at the point
in time that a decision is made. The organization has several options in
regards to discretionary cost. Discretionary costs can be moved forward,
delayed or cancelled from the firms expenditure plan when conditions
dictate.
Accordingly, structural
costs are obligated while discretionary costs are unobligated until some
point in time that the management commits to incurring the cost.
Discretionary costs might become structural costs when the expenditure is
committed. Discretionary costs enable an organization to be nimble to
changing conditions.
There are several natural
categories of discretionary costs. Discretionary projects are typically
undertaken to improve a process efficiency and effectiveness. A
discretionary event is a one-off instance of a process. The firm only
commits resources to the single event. Related future events must be
independently justified.
TDC
= sum
(DP + DE)
Where: DP:
discretionary projects
DE: discretionary events
Cost behavior patterns are
also reliant on the treatment of resource capacity. The decision to purchase
a resource is, first and foremost, a process decision as has been previously
discussed. Each resource has a capacity and a cost dimension. A full time
labor has approximately 2,000 available work hours per year depending on a
firms policies. A machine has an availability of approximately 8,700 hours
(three shifts a day, seven days a week) less maintenance and down time.
Resources are finite (most
commonly integers) while consumption occur in fractions. Capacity (Resource
capacity corollary) separates resource into its used and unused
components. The veracity of capacity consumption is independent of how the
cost system treats resource capacity. The reality of process transformation
is that resource consumption is not always perfectly matched with resource
availability.
The decision to purchase a
resource involves a capacity decision. Capacity decisions, in turn, are
dependent on a myriad of factors including projected activity level, risk of
shortage, resource flexibility to name a few. Unused capacity is both an
opportunity and a risk. An unused resource that can be turned into a process
consumed resource can create value at a greater rate than the cost consumed.
Unused capacity is an important buffer to changing activity level.
The firm's cost equation
can be expanded to include capacity considerations.
TC
= (TSCu + TSCn) + TDC
Where: TSCu:
total structural cost used
TSCn: total structural cost unused
How capacity is treated by
cost analytics will result in significantly different cost behavior
patterns. A cost analytic that ignore resource capacity in computing unit
cost result is influenced by both changing activity levels and process
variation. The preferable unit cost calculation is to separate used and
unused capacity:
UCc
= ((TSCu + TSCn)/Q) + TDC/Q
UCc = (USCu + USCn)
+ UDC
Where:
UCc: Unit cost (capacity)
USCu: Unit used capacity cost
USCn: Unit unused capacity cost
UDC: Unit discretionary cost
Unit cost
(capacity) separates the unit cost calculation from normal process
variation. The separation of unused capacity removes the bias caused by
capacity utilization swings.
Process Economic
Assumptions
There are a multitude of
assumptions that underlie process economics. The key assumptions include the
following:
- Process
takes precedence over resources. A firm's
cost behavior pattern is most influenced by its choice of processes and
its estimate of process volume. These decisions determine a firm's
probability of long term success or failure.
- Resources
are bundled together by process transformation logic.
The cost behavior of this bundle of cost is directly related to how a
process functions. The amount of resources dedicated to a process
depends on the activity level (activity level volume) and resource
capacity. The commitment to a strategy entails a commitment to provide
the basic resources needed to perform the firm's processes.
- Structural
costs represent a long term commitment to provide capability and
capacity. A structural cost is one that is
embedded in the process. Resource consumption is tied to process
transformation logic. Resource transformation logic can and should be
continuously improved. The goal of process improvement is to improve
process efficiency and effectiveness.
-
Discretionary resources are uncommitted until events warrant committing
additional resources to a process.
Discretionary costs are investments in expanding process capabilities or
process improvement initiatives. Discretionary costs are planned process
costs that can be delayed or abandoned based on current conditions that
exist at a certain point in time. Discretionary costs are not structural
costs until they are committed. Discretionary costs enable an
organization to be nimble to changing conditions
- Resources
have a finite capacity. Capacity is either
used or unused. Capacity cost display a stepwise cost behavior. Unused
capacity is converted into used capacity until exhausted. The firm must
then acquire a new unit of resource.
Implications
Process economics
challenges the robustness of "truth" rather than the instance of truth. Is
it true that resources exhibit a fixed and variable relationship to activity
volume in the short run? Absolutely! Is it equally true that the process
requires a bundle of resources that are integral to effective process
transformation? Absolutely! The question is which view of truth takes
precedence over the other. The choice rests with which foundation best
mirrors natural cost behavior which, in turn, leads the better decision
making. Here it is hypothesized that processes should have precedence over
resources in understanding economic behavior.
To begin, the
distinction between fixed and variable is an illusion. It is often
easier in today's internet connected world to buy or sell tangible assets
than it is to layoff an employee. Ebay, and other internet sites, offer a
worldwide accessible marketplace to buy and sell many tangible assets. High
value capital assets are often leased than purchased. Meanwhile, employee
rights are codified in law and company policy. Employees can file lawsuits
if they believe their rights have been violated. The legal costs can be
substantial even when an organization prevails in the legal proceedings.
Functional and employee
specialization further blur the distinction between fixed and variable. An
organization must pay a market based price to acquire the services of an
employee. The price (salary) can vary dramatically based on the education
and experience level of the person. An organization must pay a premium
salary to shift a person to a job that requires less skill. Likewise, to
shift a person to a higher skilled job typically requires incurring training
and learning curve costs. Union restrictions also inhibit worker
flexibility. Any attempt to apply meaningful fixed and variable
distinctions is a slippery slope in today's topsy-turvy world.
The fixed and
variable distinction is also a psychological barrier to creating value.
A firm that bestows a fixed characteristic on a resource often limits the
attention given to the resource. Considering a resource as a component of a
process results in improving the entire bundle of resources both those
neoclassical economics considers fixed and variable as part of a continuous
improvement program.
Process logic provides a
much better understanding of organizational economic behavior. There
is a direct correlation between an organizations processes and its resource
consumption. Organizations fund processes to acquire capabilities.
The investment a firm makes in capabilities should reflect the organizations
strategic priorities and represents a committed course of action.
All resources
possess a capacity component. Every resource
is finite. Each transformation cycle consumes a bundle of associated
resources. What remains of the unused resources are available for future
consumption. Excess unused resources tie up a firm's valuable capital. Too
little unused resources cause bottlenecks and lost revenue. The challenge is
to balance capacity and has been for eons. The cost behavior pattern of
firms is reflected in their successful, or unsuccessful, search for balance.
The concept of process capacity management takes precedence over fixed and
variable.
A firms breakeven point
occurs when revenues equal structural costs. A structural cost requires
significant management effort to reduce or eliminate the related cost.
Discretionary cost is a point in time decision whether to authorize the
expenditure. Organizations become more nimble organization when it is able
to shift costs from structural to discretionary.
Conclusion
The introduction of process economics is essential to understanding a
firms cost behavior patterns. A hierarchy of cost behavior begins with
processes. Processes follow from strategic decisions that reflect the firms
commitment to provide capabilities and capacity. Processes beget allocating
structural resources to processes and committing discretionary resources to
enhancing capabilities and improving efficiency. Processes then beget used
and unused capacity. Resources must be acquired prior to performing a
process. Resources have varying amounts of capacity. Balancing process
resource needs with resource capacity is an essential role of management.
The
search for a better understanding of economic cost behavior is essential to
both accountants and economists. While each branch of knowledge has its
unique ways of calculating costs, there should not be differences in
understanding a firms cost behavior. Such knowledge should be common to
both.
Today
economic theory is a collection of postulations to explain situation
specific cost behavior. Each postulation taken independently is founded on
logic. However, logic can look less logical when viewed from a different
perspective. Process economics seeks to create a common foundation between
economics and accounting. Cost behavior patterns happen. Natural laws shape
the cost behavior patterns. Process economics seeks to understand process
transformational logic.
Economic
theory must be translated into accounting decision tools be useful. The
decisions that are made by a firm's top management should emanate from
microeconomic logic and data. Logic that inadvertently leads managers to
make mediocre decisions may eventually prove fatal to their companies and an
economy.
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