Bikes Unlimited is planning its monthly sales. They have recently concluded a successful advertising campaign and expect that sales will increase 10 to 20 percent. They need to know what happens if they adjust manufacturing to meet the predicted increase in sales and their predictions of sales are in fact true. How will increased sales volumes impact profit? First, you have to identify how costs behave with changes in sales and production – behavior depends upon whether the costs are variable, fixed, or mixed. Once you have classified our costs, you can set up an income statement in a "contribution-margin" format, that will give management a major tool in their decision making.
The key to understanding and being able to classify a variable cost is to remember that you are thinking about how costs behave relative to production. Variable costs will fluctuate based on how much product is sold. The cost of purchasing chrome tubing for Bikes Unlimited is an obvious variable cost, some variable costs are not so obvious.
Fixed costs are incurred whether Bikes Unlimited sells zero units or a billion units. The payment of the annual lease on Bikes Unlimited's factory/warehouse is a good example of a fixed cost: Even if Bikes Unlimited chose to make no bikes, it would have to continue to pay its lease. There are two kinds of fixed costs: (1) some are "committed", those that must happen, such as the lease payment stated above, and others that are discretionary, such as advertising or research and development. Both of these activities could be suspended in the short term.
Bikes Unlimited also has mixed costs which have both a fixed and a variable components. You can think of your cell phone bill as a mixed cost. You pay a flat fee (fixed cost) for a certain number of minutes. If you exceed the set amount of minutes, then you have to pay by the minute (variable cost). Bikes Unlimited pays its sales staff based on a base salary plus a commission based on units sold and, finally, a year-end bonus based on overall profitability, which demonstrates all three cost behavior patterns.
Short/Long Term and the Relevant Range
Both short- and long-term costs are important factors in managerial decision-making. This section covers these variables and discusses them in terms of what is called the "relevant range" (also covered in the final section in this unit). The relevant range is the portion of the total cost curve that is beyond increasing returns to scale and before decreasing returns to scale. Within the relevant range, a doubling of variable cost inputs should approximately result in a doubling of output.