Variable cost per unit vs. fixed costs: The key to effective business cost management

When managing a business, understanding the cost structure is crucial as it directly impacts investment decisions, pricing, and growth planning. Variable costs per unit and fixed costs are the two main components that make up the total operating costs. Managing both effectively is fundamental to long-term growth and financial sustainability.

How Are Production Costs Categorized? Understanding Cost Structure from the First Letter

The cost structure of any business typically consists of two basic elements, each with its own characteristics and influence on management decisions.

Analyzing these costs helps companies evaluate production efficiency, identify break-even points, and plan expansion wisely. It also aids in assessing the impact of market changes, such as increasing or decreasing production volume, which affects costs and profits differently.

Fixed Costs That Do Not Change, Variable Costs Per Unit Vary with Production

Fixed costs are expenses that remain unchanged regardless of whether the business produces more or fewer goods. They are obligations that must be paid whether operations are ongoing or halted.

In contrast, variable costs per unit change with the production volume. As the company produces more units, these costs increase proportionally; when production decreases, they decrease accordingly.

Understanding this fundamental difference allows managers to prepare accurate budgets and plan expenditures wisely.

Key Characteristics of Fixed Costs

• Stable and Predictable: Fixed costs are consistent, enabling companies to forecast and plan finances in advance.
• Cover Long-term Commitments: Often related to long-term contracts such as rent, salaries of permanent staff, and loan interest.
• Indicate Minimum Profit Levels: Fixed costs help determine the minimum sales needed to avoid losses.

Distinguishing Variable Costs Per Unit Clearly: Practical Examples

Fixed Costs Faced by Companies

Examples of fixed costs that most businesses bear include:

• Rent or Loan Payments: Companies renting office or factory space pay rent regularly, regardless of production levels.
• Salaries and Employee Benefits: Salaries for management and other permanent staff are fixed.
• Business Insurance: Regular payments for asset, liability, and other insurances.
• Utilities (Fixed Portion): Part of electricity, water, and utilities are fixed costs.
• Loan Interest: Fixed interest payments scheduled over time.
• Asset Depreciation: Buildings and machinery depreciate at a fixed rate annually.

Variable Costs Per Unit That Change with Production Volume

Examples of costs that fluctuate with production or sales volume include:

• Raw Materials and Components: The amount of materials used increases with the number of units produced.
• Direct Labor: Wages for production workers calculated based on units or actual hours worked.
• Production Energy Costs: Electricity used by machinery increases with production volume.
• Packaging Materials: The number of boxes, bags, or packaging materials increases with the number of products.
• Shipping and Delivery Costs: These costs rise with the volume of goods shipped.
• Sales Commissions: Salespeople or agents earn commissions based on sales generated.

How to Calculate Total Costs and Control Variable Costs Per Unit

Total Cost Formula

Total Cost = Fixed Costs + (Variable Cost Per Unit × Number of Units Produced)

This formula helps companies estimate total costs at different production levels. Understanding it allows managers to plan production and pricing accurately.

Practical Calculation Example

Suppose a company produces a product with:

• Fixed costs per month: 100,000 THB
• Variable cost per unit: 50 THB
• Production volume: 1,000 units

Calculation: Total Cost = 100,000 + (50 × 1,000) = 150,000 THB

Cost per unit = 150,000 ÷ 1,000 = 150 THB/unit

This example shows the variable cost per unit is 50 THB, and the total cost per unit is 150 THB, with the difference influenced by how fixed costs are spread over units.

If the company increases production to 2,000 units: Total Cost = 100,000 + (50 × 2,000) = 200,000 THB Cost per unit = 200,000 ÷ 2,000 = 100 THB/unit

Note that the variable cost per unit remains at 50 THB, but the total cost per unit decreases from 150 to 100 THB because fixed costs are distributed over more units.

Strategies to Control Variable Costs Per Unit

• Reduce Waste in Production: Improve efficiency to use raw materials more economically.
• Negotiate with Suppliers: Secure better prices through bulk purchasing.
• Improve Production Techniques: Invest in new technology to increase efficiency and lower per-unit costs.
• Train Employees: Skilled workers produce faster and more accurately, reducing waste and increasing productivity.

Strategic Decision-Making Based on Cost Analysis

The Importance of Cost in Planning

Companies must decide whether to invest in automation or not. As direct labor costs (variable costs per unit) increase steadily, investing in machinery can raise fixed costs but significantly reduce variable costs per unit.

In such cases, calculating the break-even point helps determine if the investment is worthwhile. If future sales volume is expected to be high, this investment may be justified.

Setting Appropriate Product Prices

Pricing should consider both variable costs per unit and the proportion of fixed costs per unit. Selling prices must exceed total costs to generate profit.

Long-term Growth Planning

Companies with high fixed costs and low variable costs benefit from increasing sales volume, as the cost per unit decreases—this is known as economies of scale.

Cost Reduction and Profit Enhancement Strategies Through Effective Cost Management

Identify High-Cost Areas

Analyze fixed and variable costs to find areas for improvement. Focus on costs that tend to rise and can be controlled.

Reduce Fixed Costs When Possible

For example, move to cheaper office locations or outsource certain tasks instead of hiring full-time staff.

Increase Sales Volume to Spread Fixed Costs

Higher sales volume reduces the fixed cost per unit, increasing profit margins.

Continuously Improve Production Efficiency

Reduce waste, speed up production, and improve quality to lower variable costs per unit.

Use Cost Data for Decision-Making

Regularly monitor actual costs against estimates, generate cost reports, and enable managers to make quick, accurate decisions.

Summary

Understanding variable costs per unit and fixed costs is fundamental to effective business management. Fixed costs are expenses that must be paid regardless of activity level, while variable costs per unit fluctuate with production or sales volume.

By analyzing the relationship between these costs, companies can set appropriate prices, plan production, evaluate break-even points, and make informed investment decisions.

Managers with a deep understanding of costs can control variable costs per unit, manage fixed costs efficiently, and monitor total costs effectively, leading to better competitiveness, financial stability, and sustainable growth in the long run.