Variable and Fixed Costs - Essay Example

Running head: VARIABLE AND FIXED COSTS Variable and Fixed Costs (Course Name)29th November 2012Variable and Fixed CostsAbsorption income statement entails the use of all costs by a manufacturing concern to produce the products. This implies that the prices of every unit produced by a firm include direct materials, direct labor, as well fixed and variable overheads. Key examples of costs that are covered under the absorption income statement include wages to salaries, overheads costs and the raw materials used in the production facility.

On the other hand, variable income statement organizes costs incurred by business by their behavior. Additionally, it indicates the relationship existing between fixed costs and variable costs. Unlike in the absorption costing, all the variable expenses under the contribution income statement are deducted from the sales to get the contribution margin. This is followed by deducting fixed costs from the contribution margin to get the net profit or loss for a particular period.Under the absorption costing and contribution costing the net income is always the same only when the inventory is the same.

Otherwise the income is higher under the absorption income statement that in the contribution income statement when the inventory is higher. Even though the fixed production costs under the contribution income statement are aggregated at the lower part of the income statement, all the variable and the administrative expenses are taken into consideration during the computation of the net profit thus making the two methods to have similar net profits when the income is the same. However, the similarity ends when a firm increases its inventory.

Companies should create another income statement in a different format in order to undertake a comparison. Based on the impact of the inventory on the income of a company, an extra income statement helps the financial managers to show actual income of the company. One of the major aspects that are depicted by the preparation of income statement using the contribution margin format is that it helps the management in determining the proportion of the expenses that has impact on the revenues of a company.

In this regard, it helps the management on adopting ways of minimizing such expenses in order to increase the profits. It is vital to note that fixed costs in the manufacturing of any product must be incurred. This implies that under the variable costing techniques, management is assisted on how to recover the fixed expenses in order to survive.Break-even analysis is a useful tool especially to the marketers. It entails the sales volume expressed in units that is needed in order to cover the costs incurred by a firm (Dayananda et al, 2002).

For example, a new business venture must come up with a break even analysis in its business plan in order to emulate extensive marketing strategies as a way of selling adequate units to offset the initial costs. One of the major aspects of a break-even analysis is that it depicts the relationship between variable costs, fixed costs and selling prices. Example below indicates the computation of a break-even for ABC Company.Fixed CostsOffice rent $ 120Monthly insurance $ 50Total fixed costs $170Variable costsRaw materials $ 5Labor $ 4Total variable cost $ 9Selling price $10Break even point=Fixed costs/selling price-variable costs (Dayananda et al, 2002).

Break even point=$170/ ($10-$9)Break even point=$170/$1Break even point=170This implies that ABC Company must sell 170 units per month to breakeven.ReferencesDayananda, D., Irons, R., Harrison, S., Herbohn, J and Rowland, P. (2002). Capital Budgeting: Financial appraisal of investment projects. Oxford: Cambridge University Press.