Explain the effect of a sales volume increase on the total fixed costs, unit fixed costs, total variable cost, and unit variable cost
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the basic (vertical) income statement is
- variable costs
= contribution margin
- fixed costs
= net income
(if taxes are involved, CM minus FC is taxable income, TI times the tax rate is NI)
A sales increase of 10% increases variable costs (DM, DL, SG&A, VOH...) by 10%. Fixed costs remain fixed, regardless of sales volume increase or decrease, within the relevant range. (For example, a package delivery company could handle 200 packages + or - a few with only one truck. if each package was a tenth of a percentage point, the company could have about a 20% sales volume increase before they have to buy a new truck. At 30%, or 300 packages, the company is outside of the relevant range and fixed costs increase. Both per unit and total, because 1 truck- or 200 packages- is a fixed amount. another truck would be double the fixed amount, and the total costs would be spread over more units.)
Before we examine the effect of increase in sales volume on each of total fixed cost, unit fixed cost, total variable cost,and unit variable cost, it would help to understand the nature of costs involved manufacture and sale of any product.
Though exact amount of costs involved in manufacturing and sale of a product will depend on the product and the nature of manufacturing and selling methods used, we can identify a common pattern of costs of all product costs.
The total cost of a product can be divided in two parts - fixed cost and variable cost. The fixed cost, as the name implies is fixed - is does not change with change in sales volume. Variable cost is varies directly in proportion to the volume of sales. For example, if variable cost of manufacturing and selling one unit of product is 'x' dollars then the cost of producing 'n' units of product will be 'n' times ''x' dollars. Thus the behaviour of various types of cost can be expressed by following equations:
Fixed Cost = F .
Variable cost = n x V
Total Cost = F + (n x v)
'F' is a constant
'n' is number of units sold
'V' is variable cost per unit
Based on these equations we can examine the impact of increase in sales volume on different types of costs.
Total fixed cost: This will remain same irrespective of sales volume.
Unit fixed cost: Unit fixed cost will be equal to total fixed cost divided by sales volume. This will reduce with increase in sales volume.
Total variable cost: This cost will increase in direct proportion to the sales volume.
Unit variable cost: It will remain constant irrespective of sales volume.
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