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# Fixed and Variable Costs: Essential Building Blocks Small business

owners divide their costs into two categories. Variable costs change based on the  volume of units sold. Fixed costs must be paid regardless of whether or not sales are  being generated.    Variable costs change with sales. They fall into two subcategories:   1. Cost of goods sold ( COGS), or cost of services sold ( COSS), which is associated  specifically with each unit of sale, including: • The cost of materials used to make the  product ( or deliver the service) • The cost of labor used to make the product ( or  deliver the service)   2. Other variable costs include: • Commissions or other compensation based on  sales volume • Shipping and handling charges     Fixed costs stay constant whether you sell many units or very few.  Examples of fixed costs include rent, salaries, insurance, equipment, and  manufacturing plants. Henry Ford spent money on efficient manufacturing  equipment ( a fixed cost) but saved a fortune on labor ( COGS) by doing so. This  reduced his total costs because labor was used in each of the millions of cars Ford  produced, but he only had to pay for the plant and equipment once. For any unit of  sale, you can study its Economics of One Unit to figure out what it cost to make that  sale. Figure 7‐ 2 shows an example from a business that sells hand‐ painted vintage  T‐ shirts.

and as long as Jamaal sells roughly the same number of  each brand of bar. Costs of the four candy bars ( 36¢ 38¢ 42¢ 44¢) ÷ 4 Average  cost of the four candy bars \$ 1. Example:   Jamaal sells four kinds of candy bars at school.60 ÷ 4 Average cost of each bar 40¢ Using an average  works if the costs are close.     . A business selling a variety of products has to create a separate EOU for  each product to deter‐mine whether each one is profitable. He sells each bar for \$ 1. he should then change his EOU to reflect the higher price of the other two  bars.         What if each unit of sale is made up of a complex mix of materials and labor? The  EOU can still help you figure the COGS. a “ typical EOU” can be  used. for  example. and gross profit for the  product. other variable costs.Calculating EOU When You Sell More Than One Product Most businesses sell more  than a single product and they also can use EOU as a value measure of product  profitability. although the process will be more complex. If he can no longer get Snickers and Almond Joy at some point. Jamaal uses the average cost of his four candy  bars ( see Figure 7‐ 3). but  he pays a different wholesale price for each:   Snickers 36¢ each   Almond Joy 38¢ each   Butterfinger 42¢ each   Baby Ruth 44¢ each     Rather than make separate EOUs. When there are many  similar products with comparable price and cost structures.

Other Variable Costs The following supplies are used every time a sandwich is sold. such as napkins.). There will also be some other  variable costs. One roll is used per sandwich. The costs of the materials and direct labor for production  are called inventory costs until the product is sold. and any other variable costs: COGS a. make a list of the COGS. Each sandwich uses a fourth of a tomato.) The EOU for the turkey sandwich is shown  in Figure 7‐ 4. Employees are paid \$  7 per hour and can make 10 sandwiches per hour (we are assuming no down time  and no payroll costs). A 32‐ ounce jar of mayo costs \$ 1. Pickles cost 5 cents each.  She sells each for \$ 5. Bread  (large rolls) cost \$ 1./ 1 lb.          .  but are not strictly part of the sandwich’s production: a. Paper wrapping costs 20 cents per  foot (on a roll).Example: Denise sells turkey sandwiches from her deli cart downtown on Saturdays.16 each.60 per lb. of turkey meat ( 16 oz. Napkins cost \$ 3 per pack of  100. One napkin is included with each sale. Turkey  costs \$ 2.  Tomatoes cost \$ 1. more  than one sandwich might go into a bag. g. (In reality. Each sandwich uses two feet of paper. b. b. First. Each sandwich uses 4 oz. c. d. and plastic  bags. Each sandwich sold uses one plastic carryout bag.60. Each  sandwich comes with two pickles. The materials and labor that go directly into making each  sandwich are the COGS. One ounce of  mayonnaise is used per sandwich. Plastic carryout bags cost \$  7 per roll of 100. e. c. and 1/ 16 of a pound (1 ounce) is used on each sandwich. Lettuce  costs 80 cents per lb.92 per dozen. a paper wrapping for each sandwich. f.

This problem is addressed by depreciation. Internet service)   Salaries (indirect labor)   Advertising   Insurance   Interest   Rent   Depreciation     Most of these categories are self‐ explanatory. Fixed operating costs do not change  based on sales. A computer that will be used for 4 years will have been only  25 percent “ used up” during the year it was purchased. A  business could choose to expense a computer during the year it was bought. but depreciation may need  clarification. or can in‐ crease or decrease the advertising budget. which spreads the cost of an item  purchased by a business over the period of time during which it will actually be in  use.    An easy way to remember the seven common fixed operating costs is with the  acronym USAIIRD:   Utilities (gas. Expensing the entire cost of  the computer during that year makes the accounting records and financial  statements inaccurate. profits in subsequent years will appear to be higher than they should.   1 Fixed operating costs are not included in other variable costs because they do not  vary directly with the number of sales made. These changes are not  calculated on a per‐ unit basis. Fixed operating costs are not included in  COGS (or COSS) because they are not direct costs of creating each product ( or  service). A sandwich shop has to  pay the same rent each month whether it sells one turkey sandwich or a hundred. telephone. In this way.     Fixed costs are “ expensed” during the year the money is spent. If more than 25 percent of the computer’s cost is expensed in  the first year.  However. and the like. it sub‐tracts that cost from the gross profit for that year. however. they are not included in the EOU. to reflect wear and tear on the asset. If the computer will not be replaced for 4 years.   Depreciation is the percentage of value of an asset subtracted each year until the  value becomes zero. then the full price should be  shown as an asset and then expensed 25 percent each year.Fixed Operating Costs   Costs. the cost of  . but that  would not be accurate. Some  items. such as a computer. the owner of the shop can change the cost of the rent by moving. When a company  pays for advertising. such as rent or the Internet bill. therefore. are called fixed operating costs. electric. which do not vary per unit of production or  service. the income statement will show a lower profit than it should. It is a method used to “  expense” (listed as an expense on the income statement) costly pieces of equipment.  Meanwhile. are expected to last for a number of years.