Fixed vs. Variable Costs: Two Key Factors

The concept of fixed and variable costs does not make any sense unless you first consider two factors: the time frame and the relevant range.

Time Frame

Most costs are fixed in the extreme short run. Given a 24-hour time frame, it would be difficult to change most costs. For example, terminating an employee generally requires severance pay that stops the cost from disappearing immediately.

On the other hand, all costs are variable in the extreme long run. Given a 40-year time frame, even multi-billion dollar plants can be retired and added.

Managerial accounting generally uses a time frame of one year for classification of a cost as fixed or variable.

Relevant Range

Given an infinite range of activity, no cost would be fixed. Let's consider depreciation of manufacturing facilities. If it takes one $2 billion-dollar plant to make 500,000 automobiles per year, then it will take two such plants to make 1,000,000, three such plants to make 1,500,000, and so on. No organization expects to operate over an infinite range of activity. If the above auto company expects "the relevant range" of demand for its vehicles to be between 1,300,000 and 1,500,000 vehicles, then it will attempt to operate with three plants, no more and no less. With $6 billion invested in plants, depreciation will be fixed for quite a few years, even though we are only interested in one year.

Keep in mind that different organizations have different relevant ranges. For example, Toyota and GM build more cars than BMW, so their relevant range would be much higher than BMW's relevant range. Also, because different organizations have different relevant ranges, a fixed cost for one organization can be a step cost for another. This will be more apparent when you cover the part of this presentation on step costs.

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