Fixed, variable and total costs

Manufacturing costs, apart from being split into direct and indirect costs, can also be divided into fixed costs and variable costs. Fixed and variable costs are added together to calculate total costs in the following formula:

 Total costs = Fixed costs + variable costs 

Fixed costs are those costs, such as factory rental, capital eqipment repayments and permanent staff salaries, which at least in the short or medium term, remain unchanged regardless of the level of output achieved.

Variable costs are those costs, such as raw material purchases, wages and electricity, which vary directly according to the level of output achieved.

Breakeven point

Once a company has achieved an output that generates sufficient revenue (or income from sales) to cover both the firm’s fixed and variable costs, it will have reached a breakeven point. At this point, total revenue is equal to total costs. Above breakeven, the only additional costs incurred should be variable costs; therefore, any price per unit that exceeds the variable costs, will yield a profit.

Marginal costing

Marginal-cost pricing involves basing the price on the variable costs of producing a product, not on the total costs (i.e fixed and variable costs).

Obviously, the company cannot, within its local markets, sell some of its stock at normal prices and the rest at marginal-cost prices. All prices would have to be reduced with the result that a greater volume of output would be required to reach a breakeven point. The exporter can, however, take advantage of cost pricing in certain export markets becuase it would be difficult for the import to directly compare the export price with the domestic selling price – but the target markets should be sufficiently divorced from the company’s main markets to prevent price levels in the local markets being affected.

Marginal-cost pricing should only be considered when the profitable use of resources, such as an alternative market which may offer high price levels, or a more profitable product that could be manufactured at the same plant, can no longer be identified. It has obvious attractions for markets where lower income levels dictate lower prices or where foreign competition is such that a company cannot compete at normal price levels. However, it should relate only to short-term business aimed at disposing of temporary surpluses following the construction of new plant or a seasonal fall-off in other orders.

An example of marginal cost pricing

To illustrate the concept of marginal costing, let us use an example:

Assume there is a local company that produces backpacks. The firm has the capacity to produce 60 000 backpacks per year given the size of its factory and the number of machines it has available (these are large capital-intensive machines that cannot easily be increased in number without incurring long-term financing costs). The comapny, irrespective of whether it achieves any sales whatsoever has fixed costs amounting to R700 000 per year (including management and permanent staff salaries, factory rent, insurance costs and capital equipment repayments).

The variable cost of producing a single backpack for the domestic market, is R42 per unit. This covers materials, wages, electricity, yarns, dyes, etc. The variable cost for producing a single backpack for the export market is R59 per unit. The extra R17 covers international transportation, additional insurance, additional labelling, special packaging, import duties and the import agent’s commissions.

Currently the firm sells 45 000 units domestically. The breakeven cost per unit of these domestic sales are therefore:

 

Breakeven cost per unit	= Total costs / total number of unit solds
	= (Fixed costs + variable costs) / total number of unit solds
	= (R700 000 + (R42 x 45 000 units)) / 45 000
	= R2 590 000 / 45 000 units sold
	= R57.56 per unit

 

If this company now generates an export order for 10 000 units per annum, the breakeven cost of this export order will be calculated as follows:

 

Breakeven cost per unit	= Total costs / total number of unit solds
	= (Fixed costs + (variable costs for domestic sales + variable costs for export sales)) / total number of unit solds
	= (R700 000 + ((R42 x 45 000 units) + (R59 x 10 000 units))) / 55 000
	= (R700 000 + R1 890 000 + R590 000) / 55 000
	= R3 180 000 / 55 000
	= R57.82 per unit

 

Using marginal costing methods, however, the firm would ignore fixed costs for its export sales and would calculate the per unit price based on variable costs alone. This would be done as follows:

 

Breakeven cost per unit (Marginal costing method)	= Total variable costs / total number of units sold
	= (Variable costs for domestic sales + variable costs for export sales) / total number of units sold
	= ((R42 x 45 000 units) + (R59 x R10 000)) / 55 000 units
	= (R1 890 000 + R590 000) / 55 000
	= R2 480 000 / 55 000
	= R45.09