Fixed costs remain constant in total regardless of changes in volume of production and sales, upto a certain level of output.
There is an inverse relationship between volume and fixed costs per unit. If volume of production increases, the fixed costs per unit decrease.
Thus, total fixed costs do not change with a change in volume but vary per unit of volume inversely. Variable costs vary in total in direct proportion to changes in volume.
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An increase in the volume means a proportionate increase in the total variable costs and a decrease in volume results in a proportionate decline in the total variable costs. There is a linear relationship between volume and variable costs. They are constant per unit.
Many costs fall between these two extremes. They are called as semi- variable costs. They are neither perfectly variable nor absolutely fixed in relation to changes in volume.
They change in the same direction as volume but not in direct proportion thereto. To take an example, electricity bills often include both a fixed charge and a charge based on consumption. This is known as two part tariff.
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The distinction between fixed and variable cost is very important in forecasting the effect of short-run changes in volume upon costs and profits.
This distinction has given rise to the concepts of Break-Even chart, Direct costing and Flexible Budgets.
In some manufacturing enterprises two or more different products emerge from a single raw material. For example a variety of petroleum products are derived from the refining of crude oil.
In a cigarette factory different parts of the tobacco leaves are used for different qualities and products. They are identifiable as separate products only at the conclusion of common processing generally known as the split off point.
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The costs incurred upto the split off point are common costs- costs which cannot be traced to the separate products in any direct or logical manner.
Still for managerial analysis these costs should not be identified with individual products if it is not meaningful and useful to identify them.
The identification of such costs, however, becomes meaningful in decisions like the discontinuance or otherwise of a product, addition of new product, modification or redesigning of existing products and selection of the most appropriate price differential among members of an existing product line.
Some common costs are unaffected by the change that has to be decided upon (e.g. cost of factory building).
Fixed common costs need not be allocated since they are irrelevant for any decision, and will remain constant. Common costs that vary with the decision must be allocated to individual products.
For product costing, it is desirable to distinguish between two broad categories of common products i.e. joint products and alternative products.
When an increase in the production of one product causes an increase in the output of another product, then the products and their costs are traditionally defined as joint.
In contrast when an increase in the output of a product is accompanied by a reduction in other products, they may be called as alternatives products. Slag and steel are joint products, but steel rails and steel bars are alternative products.
For joint products cost problems relate commonly to the incremental effect of an increase in the output rate to meet new demand for one of the firm products.
Such an increase involves higher output for all the products. This may call for reduction in the prices of some joint products to get rid of their increased output.
Then the added revenue from one joint product must cover not only the added cost of the whole product package but also any loss of revenue from reduced prices of the other joint products.