Variable Cost and the Fixed Cost

Variable cost

  1. Assume that we are going to use wood to manufacture a table.The wood would be raw material that is used to manufacture the table. Let’s assume that each table requires Rp.500,000 of wood. If you manufacture one table, the unit variable cost that is the amount of wood per table, would be Rp.500,000. And total wood cost for one table also would be Rp.500,000.
  2. But look at what happen to go manufacturing 2 tables. When we manufacture 2 table, the amount of wood used per table is still Rp.500,000, so a unit variable cost stay still constant at Rp.500,000. But look at what happen to the total variable cost when we manufacture 2 tables. Total wood cost now has changed to Rp.1,000,000 from Rp.500,000.
  3. When we manufacture 3 tables, the amount of wood per-table does not changed. That stay the same as Rp.500,000 per-table. So your unit variable cost stay constant Rp.500,000. But total wood cost now has gone up to Rp.1,500,000.
  4. What conclusion can we draw from this table? The conclusion are that a unit variable cost stays constant with changes in volume, but your total variable cost changes with changes in volume. If your volume is up, total variable cost goes up. If your volume drops, total variable cost comes down. So the wood is the example of variable cost. And I have just illustrated the behavior pattern of both unit variable cost as well as total variable cost.
  5. One of the assumption we make here is that there is no volume discount. Whether we buy small amount of wood, whether we buy large amount of wood, we are going to continue to pay the same amount for each square of wood. That’s assumption here, there is no discount given for purchase.

Variable Cost

Fixed cost

  1. Let’s pay attention now to fixed cost. We assume that fixed cost we have is rent, rent of Rp.15,000,000 a month. If we have to pay Rp.15,000,000 a month, let’s see what would be the behavior pattern of unit fixed cost and total fixed cost as we change the volume of tables manufactured.
  2. When we manufacture one table, total rent I pay to my land owner is Rp.15,000,000, because my land owner does not care whether I make 1 table or 10 tables. He still want his Rp.15,000,000. But if I would allocate total Rp.15,000,000 among the tables manufactured. In this case only one single table get allocated entire Rp.15,000,000 of rent. So my unit fixed cost is also in this case Rp.15,000,000.
  3. But look at what happen to go to 2 tables. My land owner still want Rp.15,000,000 of rent, doesn’t he? So my total rent fixed cost still stay the same at Rp.15,000,000, but when I go to allocate the Rp.15,000,000 among the 2 tables that I manufactured, then this time each table picks up only Rp.7,500,000. So my unit fixed cost drops from Rp.15,000,000 per-table to Rp.7,500,000 per-table. But total rent cost stay constant at Rp.15,000,000 regardless of which I manufacture 1 table or 2 tables.
  4. So when I manufacture 3 tables, my land owner still want the same Rp.15,000,000 of rent. Total fixed cost at 3 tables still remain constant at Rp.15,000,000. But look what happen to my unit fixed cost. Each table now picks up only Rp.5,000,000 of rent.
  5. So what conclusion can we draw about this behavior patterns of fixed cost from this example? Your unit fixed cost changes inversely, they changes in volume. It was Rp.15,000,000 first, then Rp.7,500,000, then Rp.5,000,000.
  6. But look at total fixed cost as I said before. Total fixed cost does not change with changes in volume, stay the same within the relevant range. What I mean by this term relevant range? In this case let’s assume for instance that if I were to operate my factory 24/7, 3 shift a day, let’s assume that my manufacture is maximum of 10,000 units. So in this case we would say in this example, relevant range is between 1 unit and 10,000 units. What is that mean? What we are saying is total fixed cost is Rp.15,000,000 as long as I stay within relevant range. But If I want to manufacture more than 10,000 tables, I would have probably rent another building and pay another Rp.15,000,000 of rent. If I manufacture over 10,000 units tables, then my fixed cost would increase, go path Rp.15,000,000 because I am going outside of my relevant range.

Total cost and Unit cost

FixedCost

  1. Look at the effect on your total cost. Your total cost is equal to your total fixed cost plus your total variable cost. We can express the same equation on a unit cost basis, so my unit cost will be equal to my unit fixed cost plus my unit variable cost. So let’s look at this table to understand the effect of fixed cost and variable cost on my unit cost. If I go to 1 table, from a previous table, my unit fixed cost is Rp.15,000,000. My unit variable cost is Rp.500,000. So my unit cost is Rp.15,500,000 combining the two.
    • Total Cost = Total Variable Cost + Total Fixed Cost
    • Unit Cost = Unit Variable Cost + Unit Fixed Cost
  2. But look at what happen to my unit cost when I manufacture 2 tables. Now my unit fixed cost is Rp.7,500,000. My unit variable cost stay the same Rp.500,000. So in this time total unit cost has dropped from Rp.15,500,000 to Rp.8,000,000, lot cheaper to make 2 tables than to make 1 table.
  3. And see how that unit cost drop when I make 3 tables. What happen to my unit fixed cost? My unit fixed cost is down to Rp.5,000,000, but my unit variable cost does not change. It stay the same Rp.500,000. So now my total unit cost is only Rp.5,500,000.