In traditional cost accounting for manufacturing, categorizing costs as fixed or variable has been part of accepted practice for a long time. In recent years, the practice has diminished because this information was generally less useful or not timely enough for decision-making, and it is not required for regulated financial reporting. Also, the traditional calculation of fixed and variable costs has many flaws. However, if these flaws are corrected, insights into the nature of costs can contribute to better decisions and support operational improvements.
The first step is to eliminate the use of the current general ledger product cost information for guiding decisions. This purely financial model does not typically reflect resource and process causal relationships. Replace it with a cost model that clearly reflects an operational model of resource and process causal relationships. Manufacturing has dramatically shifted from variable direct costs to resources and costs that have been categorized as fixed overhead. Illustrating these evolving causal impacts with money requires understanding operational relationships and systems. Monetary metrics need to reflect the operational flow of resources to be useful for decision-making.
The second step is to correctly define the terms “fixed” and “variable.” A misleading rule of thumb that is often wrongly used to define these terms says variable costs are avoidable and fixed costs are unavoidable. Another frequent mistake is to assess any cost as fixed or variable against product volume. The correct way to assess a cost as fixed or variable is to look at the relationship of a resource or resource group to its direct output rather than to a product, which might be several causal steps distant. This assessment usually results in both a fixed and a variable component, not simply one or the other. For example, a machine maintenance team’s supervisor’s salary and the team’s benefits are a fixed cost while the technician salaries are variable with the maintenance level required. For many indirect support resources, it is common for the initial determination of fixed and variable costs to change as their output is used by other resources in the production process. For example, electricity is initially variable until it is used to maintain a required temperature in a production facility. Then it becomes a fixed cost of production.
The third step is to track and examine the use of resource capacity. Any resource has a mix of productive time (doing what it was hired or acquired to do), non-productive time (essential activities like training, maintenance or waiting for repairs/setups) or idle/excess time (no productive work to do). Each of these categories of capacity use require different handling by a cost model. For example, a production labor team’s productive time will be variable with product volume. However, it will still have fixed costs such as the supervisor, mandatory safety and human relations training (nonproductive time), wait time for unscheduled maintenance or other problems (nonproductive time) and benefits. These costs should be applied to product cost, but they should be identified in their fixed and variable components. Idle/excess time should not be applied to product cost. It is an organization-level cost caused by poor production planning at some level, or poor sales and marketing.
Correctly defining and tracking fixed and variable costs results in a cost model that reflects operations and allows rapid and accurate insights into incremental and marginal costs. It is important to keep in mind that fixed and variable relationships exist for both cost metrics and the flow of operational quantities. There should be no difference between the two if the principle of causality is applied to create decision-support models. Unfortunately, the techniques for modeling the nature of cost are not widely taught; though German management accounting techniques, resource consumption accounting and some forms of activity-based costing incorporate them.
>>Larry White, CMA, CFM, CPA, CGFM, [email protected], is executive director of the Resource Consumption Accounting Institute, which trains and advocates for improved cost information connecting operations to business performance.
