What is a fixed cost of owning a vehicle

Matthew Z. answered • 05/14/13

Accounting Tutor with Bachelors Degree, Graduate Hours, 5 Yr Exp

Jessica B. answered • 05/10/13

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Fixed cost are defined as those which do not vary with the level of output.5

Fixed costs are the costs that do not increase and decrease with the size of the production.

The fixed costs are the costs of having a given production capacity. In the car case, these are examples of fixed costs

o insurance

o vehicle excise duty

o value loss of car because of age

Insurance and vehicle excise duty are fixed costs because they do not vary with the mileage.

Variable costs

Variable costs changes as the level of output changes.6

Variable costs are the costs that increase and decrease with the production. In the car case these are examples of variable costs:

o Fuel

o Maintenance

o Value lost on the car because of mileage

Fuel and maintenance are variable costs as they vary with the mileage

But there are also some problems. If the product is "one driven kilometer," then its obvious that the use of fuel is not the same if you drive economically or fast, in the city or on a highway, or are stuck in traffic during rush-hour. With a midsize class car it may mean a difference between a car driving 15 km/liter or driving 4 km/liter. The wear and tear on brakes, clutch etc. is also very different.

If a cab driver in northern Jutland is to sell his cab, based on the above stated reasoning, then he will promote it as a country-cab; i.e. a "northern-Jutland-Mercedes-cab" despite it having driven the same amount of miles as a "Copenhagen-city-Mercedes-cab," it has experienced significantly less wear and tear. Once again, it is not that simple to present an unambiguous coherence between product and costs.

The problematic classic treatment of variable costs

The problem of the classic cost-theory is that variable costs are treated exclusively, as variables compared to the determined unit, e.g. size of production, mileage, etc.

Other factors can equally influence the variable costs:

o Motivation for work among the employees, i.e. efficiency.

o Employee treatment of materials, machinery, equipment etc. i.e. use of resources.

o Organization of the work, i.e. the management solution.

o The more complex the production is the greater the role played by education, communication, understanding of the firm's culture etc. which is why these factors have to be optimized as well.

Only by focusing on all the influencing factors is the achievement of the lowest possible cost assured.

Costs of owning and driving a car

In the following section, fixed and variable costs are explained on the basis of the costs of owning and driving a car. The annual costs of owning and driving a car are, for the sake of simplicity, illustrated in figure 1.3, where the mileage (Q = quantity) is depicted along the horizontal x-axis and the costs measured in DKK are shown along the vertical y-axis.

The costs are communicated as variable, fixed, and total cost functions. As seen in figure 1.3 the variable costs increase with mileage, while the fixed costs remain at the same level, independently of the mileage. Furthermore, it is clear that the total costs are the sum of the fixed and variable costs.

Some Implicit assumptions are made:

o Time horizon is a one year.

o Getting rid of the car during this year is not an option.

o Driving needs are stable, and the manner of driving remains unchanged (the mix of city and countryside, aggressive and careful driving) etc.

o Accidental costs are said to be estimable and calculable; e.g. repairs, tires etc.

Figure 1.3: Annual costs of owning and driving a car as a function of the number of kilometers driven

Determining unit of activity

Based on the car case, there are no obvious difficulties connected to defining the car's activity level as the kilometers driven. This unit seems to be both a natural and operational calculation unit. Concerning truck driving, bus driving and other machine-based services, "hours" are frequently the unit of measure, no matter if the machine works more or less. In each situation both measures can be more or less right or wrong. The costs vary in proportion to both variables, hours or kilometers, depending on the activity. But this variation is not identical in different situations.

For production firms, the number of units produced, denoted as Q for quantity, is most often the unit of determination. But for other industries such as restaurants, architectural firms, and law firms, there are no comparable measurement units. In these cases the number of hours, turnover, or even amount of costs, can be the product; as assignments differ greatly, this may be the only common denominator.

This variability means that the decision maker has exert themselves to find suitable measurement units See examples below:

o Concerning restaurants, the number of customers or the turnover typically will work as a measurement unit for the level of activity. The problem with the number of guests being used as the measurement unit is that there is a great difference in activity level, from guests who only order one course and a glass of wine, to those that order the full 5-course dinner with the accompanying wine menu. Turnover is also problematic, as the measurement of the activity level is affected by the price level, the earnings on the different products (drinks versus food), as well as price promotions. So, turnover is not without problems when applied as measurement unit

o In regards to architectural firms and law firms, the number of working hours is a natural unit of measurement for level of activity. However, when applied as measurement unit, the number of working hours involves a great deal of uncertainty. Both concerning time and finances, there is a great difference between hours worked by a newly educated (working slowly at a low wage) individual as compared to a more experienced (working fast at a high wage) architect/lawyer. Furthermore, more hours are not necessarily equal to a better job done. The total work load may also affect both work speed and work effort. Both professions tend to let the number of hours decide the magnitude of a given assignment.

The time horizon is decisive when separating costs into fixed and variable costs. Costs vary in conjunction with the time horizon. This fact is suitably explained by the costs of materials, workforce, machines, and rent employed in a production firm:

o In the extreme short-term, the materials employed in the production may be the only variable costs, as this employment increases and decreases with the slightest change in production. Worker salaries, depreciation of machinery, and rent are, in the span of a few days, fixed costs, as they do not adapt to the size of production. Even workers in production companies have a few weeks notice, although day laborers do exist. The short-term production planning is also dependent on whether the goods used are storable.

o In the medium-short-term the materials employed and the production-workers' salaries are both variable costs, as long as the workers can hired or laid off with relative ease. Depreciation of machines and rent are fixed costs. These are for the most components of the minimum costs that have to be covered by the sales price - unless the product has no value if it is not sold. A product that has no value if it is not sold, has a cost of 0 DKK when it is to be sold. The late owner of the travel agency Spies said: "Even if we only get 1 DKK for the last seat to Mallorca, it's better than an empty seat."

o In the medium-term, materials employed, production-workers' salaries, some administrative workers' salaries, and depreciation are considered variable. This is the case, as long as the machines can be sold at the depreciated value. Rent is a fixed cost.

o In the long-term all production factors are variable, e.g. interest is variable to the extent that the rent can be adapted to the size of production by simply moving the production to either larger or smaller facilities, depending on the production level. Fixed costs turn into opportunity costs, i.e. the cost of alternatively employing production factors, such as rent and equity.

The time horizons listed above are dependent on the firm and the business sector; thus they are relative.

E.g. companies can change all factors of production in conjunction with different time horizons. This flexibility means that the long-term is relative:

o For a window cleaning firm, possibly under one year

o For a taxi firm, possibly 1-2 years

o For a bus haulage contractor, possibly 2-3 years

o For pizza shop, possibly 3-4 years

o For a food product firm, possibly 8-10 years

o For a sugar factory, possibly within 15 years

o For a car manufacturer, possibly within 15 years

The other time horizons: extremely short-term, medium-short term, and medium-term, will then adapt to the long-term definition.

As will be apparent from cost theory later on, costs are traditionally and fundamentally, without regard to the decision issue to be solved, divided into short-term and long-term, which are defined as follows:

o Short term, where at least one factor of production is considered a fixed cost. This could be rent or office employees' (white collar) salaries, that cannot be changed within the time horizon because of giving notice requirements.

o Long-term, where all factors of production (workforce, capital etc.) are variable, which means that they can be phased out within the time horizon.

One of the motivations for text is the facilitation of understanding that such a separation always has to be seen in relation to the relevant decision-making situation. No matter how crystal clear this separation is, the reasons for decision-making must be analyzed before this distinction can be realized.

There exists a group of theories which are only applicable to the short-term, and another set of theories that only apply in the long-term. Of course there are a number of terms and techniques that apply in both long-term and short-term cases. Consequently, the time horizon is a decisive determinant for the specific decision-making occasion and it is fundamental that the time horizon is applied consistently.

Furthermore, it is important to be aware that mostly firms decide on the short-term and long-term simultaneously; e.g. if the management in a minor retail chain plans the pricing strategy for the next year, while simultaneously a reaction to the competitors' "birthday-promotion" has to be laid out for the following week.

Regarding the time horizon, the main point is that it is necessary to remain focused and constantly attentive to the applicable time horizon.

Different time horizons and decision-making situations result in different costs for the same production. No wonder costs theory is difficult.

Costs will typically react differently under production increases, production decreases, permanent changes, and temporary variations. Costs are also product dependent.

Case 1.4:

Rank Xerox has a number of issues worth contemplation concerning the number of service mechanics involved in different situations:

a) Under a permanent change in number of copiers

o If the number increases, training of new service mechanics will be initiated, so that they after 6-9 months the level will be appropriately adjusted to what is equally as efficient as the current level of mechanics.

o If the number decreases, the least efficient surplus mechanics will be laid off, which can take 3-6 months.

b) A temporary change in the number of copiers

o If the number increases, the most likely outcome is the use of overtime for a period, combined with the anticipation of hiring new people. There might be re-deployment within the organization of people who can easily be trained for the job.

o If the number decreases, there will be no laying off of workers, because of the time it takes to re-educate workers and the insecurity involved in rehiring the same level of qualified workers. These workers will typically be employed elsewhere during this period. As laying off workers is quite costly, the solution will most often be an attempt to sell more copiers. This argumentation seemingly applies to all copier-manufacturers, and a tactical progress will have to be analyzed.

i.e. the difficulties of reestablishing an important knowledge capacity or production is crucial in the adaptation flexibility.

The classification of fixed and variable costs makes room for difficult discussions, especially between decision makers (managerial economics) and accountants (financial control/management accounting), as the decision-making occasion in a control-situation is not as variable as in a decision-situation.

The basis of the discussions is the fact that they work with ex post registrations (historic) and ex ante decision-making occasions ("what-if "). Also, decision makers can be presented with many decision-making occasions for which it is unreasonable to expect that the accounting system can deliver data. Finally, decision makers are, because of the mentioned management assignments, often distinguish between fixed and variable costs, while accountants distinguish between capacity costs and unit costs, which are defined below:

o "Capacity costs are the costs that result from capacity. Average variable costs are costs that result from a specific transaction of goods"

This basic difference in definition of cost is rooted in the purpose of the costs.

The decision makers' distinction between fixed and variable costs is applied in calculating tasks concerning e.g. optimization of price or quantity, often with different time horizons, long-term price lists, short-term price competitions, frequent adaptations in capacity, both increases and decreases, different worker capacity for knowledge storing, and different products.

On the other hand, accountants' distinction between overhead fixed costs and average variable costs is applied in relation to external financial reporting, internal analyses, and internal control, e.g. predicting calculations and result-documenting calculations. Naturally, there are limits for the number of perspectives that can be applied in a single accounting and registration system; if these limits are not clearly delineated, then a massive information overload results.

The following is a simplified example of this discussion:

It is a common notion among decision makers that fixed costs, depending on decision situation and time horizon, can be spread on the costs-bearing products and thus be regarded as variable. This understanding relates to Robert Kaplan: "I'd say that, for most purposes, all costs should be considered variable." Accountants on the other hand, regard the spreading of fixed costs (capacity costs) on the products as a mortal sin. The argument is that the spreading of fixed costs results in the closure of products, which within the financial period creates a positive contribution margin. Products that create a positive contribution margin should not be closed down, considering that any contribution margin that covers fixed costs is better than no contribution margin. Michael Andersen and Carsten Rohde have appropriate input at this juncture: " difference between sales income and variable costs can be expressed by means of the contribution margin... in this way it becomes a central result-term in controlling the profitability of the firms different activities"

Another essential argument for not adding the fixed costs in optimization analyses is that the optimization theory (marginal costs = marginal revenue) shows that this results in solutions that are not optimal. The snake in this paradise is that MC is difficult to understand , as the time horizon can be uncertain.

This discussion between the micro theorists and those adhering to Activity Based Costing by Robert Kaplan, is not yet concluded. There are many arguments and case-studies from both sides. It is not the objective of this paper to solve this discussion. As everybody has such a hard time agreeing, I have to accept that: "It depends on the decision situation and horizon."