Question

In: Accounting

Why and how can companies reduce their fixed costs or switch them to variable costs? Explain...

Why and how can companies reduce their fixed costs or switch them to variable costs? Explain the advantages and disadvantages of high-fixed and low-fixed costs.

Solutions

Expert Solution

A fixed cost is a cost that remains constant in total regardless of changes in the level of activity within a relevant range (range of activity within which the fixed cost remain valid). In other words fixed costs are a function of time rather than Activity. Fixed costs have to be changed by management action. Fixed costs either are committed, facility related costs, such as rent and depreciation resulting from prior management decisions or discretionary fixed costs, such as advertising, indirect labor or selling and administrative salaries set by management during the annual budgeting process.

There are ways to reduce fixed costs of the company

1) Reducing expensive advertising media. use medias like emails, text messages, flash sales and side walk advertisements

2) Rely on security systems measures that will cut on insurance.

3) Try to reduce the rent make negotiations and sub-lease unused portion of space to generate additional income that will help to reduce rental expenses

4) Reduce salaries because labor costs are the greatest component of fixed costs it is possible by hiring temporary employees instead of permanent employees.

5) Opt for free or cheaper technology for example use another Software instead of Microsoft products.

6) Lease the asset instead of buying them.

although the company can switch fixed cost to variable cost by

1) Increase variable pay such as sales commissions and incentives and decreasing basic fixed pay

2) outsource some of the jobs because hiring employee require additional expenses

3) Rely on contract manufacturers for production

High Fixed Cost

Advantages

1) Stability : Fixed cost remains same throughout a company's production process. once a company purchases a machine the production cost remains same

2) Decrease in per unit cost : Total fixed cost will not decrease with increases in production volume, per unit fixed cost will decrease eg: The new machines set up costs $5000 and the company produces 1000 units fixed cost per unit is $5. if production output increases to 1500 units per unit fixed cost becomes $3.3

3) Depreciation tax shield : High depreciation expenses reduces the company's tax liability and most important is depreciation is a non cash expense

Disadvantages

1) If output decreases fixed cost increases that affects the net income

2) High fixed costs affects the operating leverage of the company

3) If market prices of the fixed cost item decreases it may be difficult to remain price competitive

Low Fixed Cost

Advantages

1) Increased net income : If fixed cost is low net income is increased

2) Better operating leverage

Disadvantages

1) Affects the long run of the business

2) Increased tax liability

3) Affects the stability of the company


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