Question

Why do fixed costs create an element of the unknown in the decision-making process?

Answer 1

what are fixed costs?

in accounting terminology , costs can be of 2 types .they are

1. variable cost : costs that change with the volume of production

2. fixed cost : costs that do not change with the volume of production

variable costs are the costs in the business which grows proportionally with revenue. while fixed costs are the rest which are not impacted by changes in revenue .variable costs depends on the volume produced . variable costs increase or decrease with the increase or decrease of volume of production .while fixed costs remain constant independant of the volume produced .for example , direct material costs and  direct labour costs are variable costs . if more production is required more direct material and direct labour  is required and vice versa.but depreciation , rent etc.. are fixed costs . they do not change with the volume of production . whatever the volume of production is rent / depreciation for the period remains the same.

Why do fixed costs create an element of the unknown in the decision-making process?

Fixed costs are only relevant in decision making in two cases :

1.If fixed costs are going to change as a result of the decision

2.If finance rules within your company require that all products carry some level of fixed cost allocation

fixed costs can create an element of unknown in the decision making process because it is hard to determine how to allocate or on what basis the fixed costs should be allocated to different products . accounting methods like activity based costing (ABC) can simplify the process of decision making in these situations . ABC costing enables the allocation of fixed costs more accurately in pricing decisions but also can be confusing and controversial . because the allocation of fixed costs to its exact cost drivers can sometimes be diffcult . it can be confusing to find the reason / cost driver for some type of fixed costs.  accurate allocation of fixed costs plays a vital part in the pricing decisions of the business and it can be difficult because the process of proper allocation of fixed costs requires more time and energy and is confusing because of the nature of some fixed costs .