Explain the effect of a sales volume increase on the total fixed costs, unit fixed costs, total variable cost, and unit variable cost
Total fixed cost refers to costs that are incurred by the business regardless of the number of products or services that it produces. One such cost might be the rent paid for the business’s building. The rent amount does not change with increases or decreases in production. The rent amount remains the same despite the level of output, and the business will be required to pay.
Unit fixed costs refer to the distribution of the total fixed costs for each unit of product produced. Thus, each unit gets an equal portion of the total fixed cost. The unit fixed cost is calculated by dividing the total fixed cost by the number of units produced.
Total variable cost refers to costs that change with fluctuations in output or quantity produced. Thus, the total variable cost is expected to increase in direct proportion to the amount of product produced. One such cost would be labor. More units of a product will require more labor to produce and will increase the cost of labor.
Unit variable cost is similar to unit total cost in that it refers to the amount of the total variable cost that can be equally allocated to each unit of the product.
Therefore an increase in sales volume will affect the above metrics as follows:
The total fixed cost will remain the same despite the increase in sales.
Unit fixed costs will reduce with increases in sales because the units are increasing while the total fixed cost remains the same.
Total variable costs will increase proportionally with increases in sales volume because it costs more to increase output.
Unit variable costs will remain constant despite an increase in sales volume. For instance, the amount of labor (variable cost) required to make a unit of product would remain the same irrespective of the number of units produced.
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.
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.)