The Breakdown of Fixed and Variable Cost in
Economic and Accounting Theory
By James A. Brimson and Raghu Santanam
There is agreement in neoclassical economics that, in the short term, resources display a
fixed or variable relationship to activity volume. Accounting theory and practice base
several decision making methodologies on the fixed and variable hypothesis. Chief
among these practices are breakeven analysis and marginal analysis.
This article discusses the breakdown in the relevance of fixed and variable cost in
economic and accounting theory. The breakdown has been precipitated by the transition
from a manufacturing to a service-oriented economy and the advent of the era of near
instantaneous information. Both these trends have blurred the distinction between fixed
and variable costs. In its place, the emergence of process theory and process economics
has provided a superior foundation for managerial decision making.
Fixed and Variable Cost in Neoclassical Economic Theory
Neoclassical economics asserts that the short run activity level function shows a
relationship where all inputs display a variable or fixed relationship to activity level. A
firm’s total cost (TC) is the sum of all fixed and variable costs.
TC = TFC + TVC
Where: TC: total cost
TFC: total fixed cost
TVC: total variable cost
Average unit cost (UCf) normalizes cost using activity level volume (activity level). Unit
cost is an extremely important concept in understanding economic cost behavior.
UCf
= (TFC + TVC)/Q
= AFC + AVC
Where: UCf:
Q:
AFC:
AVC:
unit cost (fixed and variable)
activity level quantity (production units)
average fixed costs
average variable costs
AFC constantly falls as output increases. In most cases, AVC will fall and then increase
due to diminishing returns. For many information products and services, AVC may even
be close to zero.
Marginal cost is the change in total cost that occurs when the activity level quantity is
incremented by an additional unit. Marginal cost (MC) is expressed mathematically as
1
the first derivative of the total cost (TC) function with respect to activity level quantity
(Q). Marginal cost addresses the question: how much will it cost to produce one
additional unit of output? MC equals slope of the total cost function and the variable cost
function.
MC = ∂TC/∂Q
A key assumption underpinning marginal cost analysis is that of diminishing marginal
returns. If we add more variable input(s) to fixed inputs, then the average unit cost will
decline. The total cost curve will flatten out as the quantity of the variable input
increases. Therefore, marginal cost may fall initially, but it must eventually increases but
at a decreasing rate.
Fixed and variable theory is an essential condition of breakeven analysis. A firm will
breakeven when its total sales or revenues equal its total expenses. At the breakeven
point, no profit will have been made, nor have any losses been incurred. Breakeven point
is the lower limit of profit when determining margins. Breakeven is calculated as follows:
BPf = TFC / (USP - AVC)
Where: BPf: breakeven point (fixed and variable defined)
USP: unit selling price
Fixed and variable defined breakeven occurs where average total cost equals price at the
profit-maximizing output. If the price is between average total cost and average variable
cost at the profit-maximizing output, then the firm is said to be in a loss-minimizing
condition. The firm should still continue to produce, however, since its loss would be
larger if it were to stop producing. By continuing activity level, the firm can offset its
variable cost and at least part of its fixed cost, but by stopping completely it would lose
the entirety of its fixed cost.
If the price is below average variable cost at the profit-maximizing output, the firm
should go into shutdown. Losses are minimized by not producing at all, since any activity
level would not generate returns significant enough to offset any fixed cost and part of
the variable cost. By not producing, the firm loses only its fixed cost. By losing this fixed
cost the company faces a challenge. It must either exit the market or remain in the market
and risk a complete loss.
Fixed and Variable Assumptions
There are a multitude of assumptions that underlie fixed and variable analysis. The fixed
and variable distinction depends on:
 The resource cost behavior pattern. The consumption pattern for any resources is
either fixed or variable to changes in the level of activity. For example, direct
material, direct labor, sales commissions, equipment related electricity and so on,
are considered a variable cost and are expected to increase with each additional
unit of output.
2
Note: Any given resource might be considered fixed or variable depending on
how it is consumed relative to a given level of activity. The important distinction
is that the fixed and variable distinction is attributable to the type of resource.
Resource characteristic (fixed, variable)

The analysis time horizon. The analysis period influences whether a cost is fixed
or variable. Fixed costs pertain to the short run. It is difficult to alter capacity in
the short term. In the long run, all costs are variable.

The level of activity. Fixed costs are constant in total and variable costs are
constant per unit of output. The activity volume (workload) is the factor that
causes the incurrence of a variable cost.

Labor is a more flexible resource than capital investments. People can perform
multiple tasks flexibly, while capital investments, such as acquiring machinery, is
most often designed for a specific use. If a capital investment isn't used for its
intended purpose, it has limited capability to be used for alternative purposes.
Thus, capital investment is a greater fixed commitment than hiring a person.
Fixed and Variable Assumption Challenges
There have been challenges to the fixed and variable assumptions in the past. The most
common challenges include:
1. All costs can be classified as fixed or variables.
There are many costs in an organization that display a multitude of cost behavior
patterns depending on the context in which the resource is used. Consequently,
splitting out fixed and variable costs depends on the assumptions made by the analyst.
2. There are a multitude of factors that impact cost behavior other than activity level
volume. A few of the more significant factors that cause changes in total cost or a
cost per unit other than activity volume include the following:
i. Economies of and diseconomies of scale — Economies of scale increase
activity efficiency as the number of goods being produced increases. Typically,
a firm that achieves economies of scale will have lower average cost per unit
over an increased number of goods without a corresponding change in activity
level volume. Thus, variable costs are in essence variable but not absolutely
variable.
Diseconomies of scale are the opposite. Diseconomies occur when increased
activity levels drive up unit costs due primarily to resource constraints.
Resource constraints lead to bottlenecks. Diseconomies of scale cause
inefficiencies within the firm and result in rising average costs.
3
ii. Relevant range — A relevant range is the upper and lower levels of activity
within which the firm expects to operate within the short-term planning horizon.
The business activity level provides a foundation upon which to base cost
behavior assumptions. It is risky to extrapolate beyond the relevant range
because there has been no analysis outside the range to base cost behavior.
Beyond the relevant range, fixed costs are not necessarily constant.
iii. Tariffs and directed taxes — Tariffs and directed taxes change resource cost
behavior. A firm can experience rising costs without a change in activity level.
iv. Trade discounts — Trade discounts will lower the cost of resources without a
change in activity level.
v. Inflation/deflation — Resource price level changes impact cost behavior.
vi. Currency exchange rates — A constantly changing international currency
exchange rate effects unit cost.
vii. Resource efficiency — Unit costs will decrease when a process is improved.
Likewise, unit costs creep up when management attention is diverted from
continuous improvement. The learning curve effect directly impacts efficiency.
3. Units are constant. Activity level is expressed in units of sales and activity level.
Determining a homogeneous sales unit is problematical.
i. Activity level (production volume) — Most firms offer a portfolio of products
resulting in a mix of potentially extremely different units.
ii. Unit selling price — Unit selling prices typically are not uniform across
customers. A discount for a large quantity purchased is a common practice.
Assessing the fixed and variable cost split can be fraught with difficulties and can be time
consuming. The best that can be said for splitting costs into fixed and variable attributes
is that it is complicated! Complexity leads to uneven application of the theory. Uneven
application of theory diminishes its relevance.
Process Economics
The inconsistency of fixed and variable classification is due to its emphasis on the prime
driver of cost behavior to be the resource type. The type of resource is situational
dependant and cannot be relied upon to be a consistent measure of economic behavior.
Associating cost changes to volume changes is problematical. Employing a process
foundation to understand economic behavior can instead provide a better decision
rationale for managers.
Process economics hypothesizes that a firm provides its products and services through a
network of processes. Each process performs its role in the product and service delivery
system. Firm’s design each process to function using process transformation logic and
4
then assigns resources in accordance with the transformation logic. The process selection
and allocation of resources to processes determines the firm’s capabilities and capacity to
perform its function.
Process logic more closely mirrors the business and natural world than neoclassical
distinction of fixed and variable. Processes better explain change and the intermediary
results that follow. Let us follow the process view of the world.
1. An organization establishes processes to achieve a desired outcome. The intrinsic
processes are necessary to provide a desired capability.
2. An organization assigns resources to its processes based on the process
transformation logic. The magnitude of resources assigned to a process governs
process capacity.
3. The first priority of a process is to achieve its targeted capability (outcome).
4. Capable processes next should strive for improved efficiency (including shedding
excess capacity for example).
A process is inexorably intertwined with resource consumption. The process
transformation logic dictates how the process transforms an input into an output and how
the resources are consumed in the transformation process. Thus, the type of resource
needed by a process is derived from the process design. The firm must hire labor with
prerequisite skills, acquire and maintain machinery, provide facilities and information
technology. All these resources are critical to a process being able to function to
accomplish a desired outcome.
Process economics places the prime driver of cost behavior on the process. All the
resources specified by the transformation logic are bundled together. An individual
resource cannot be isolated from the bundle without potentially changing the
effectiveness of the entire process. Accordingly, all resources are equally essential to
achieving a desired process outcome. The resources, in bundle, represent the firm’s
commitment to providing capability and capacity.
A theorem of process economics hypothesizes a cost behavior hierarchy.
Theorem of process resources—process transformation logic prescribes the essential
resources and how the resources are consumed in the transformation process.
1. Structural and discretionary corollary: All resources assigned to process are
either structural or discretionary. A structural resource is integral to the process
transformation logic and thus is essential to the continued effectiveness of the
process. A structural resource is committed to a process for as long of a period as
the resource is embedded in the process transformation logic. The activity level
determines process capacity. A discretionary resource is optional to the process
transformation logic and thus a point in time decision of whether to incur the cost
or not. A process will continue to operate as before if a discretionary cost is
delayed or canceled.
5
2. Resource capacity corollary: All resources have a used and unused component.
As a process consumes resources, the unused component is decreased and the
used component increases.
The process model expresses a firm’s cost structure as follows:
TC = TSC + TDC
Where: TC: total cost
TFC: total structural cost
TDC: total discretionary cost
The minimal cost of resources assigned to a firm’s processes represents a structural
commitment of costs. Structural costs behavior patterns are a result of the processes cost
behavior.
TSC = ∑ (PSC)
Where: PSC: process structural cost
The direct components of process structural costs include the common natural resources
of labor, machinery, energy, facilities, information technology and consumables.
PSC = ∑ (PL + PM + PE +PF + PIT + PC)
Where: PL:
PM:
PE:
PF:
PIT:
PC:
process labor
process machinery
process energy
process facilities
process information technology
process consumables
A discretionary cost is an optional resource that can be provided to a process to enhance
its effectiveness or efficiency. The key element that distinguishes discretionary from
structural costs is the timing of the commitment of cost. Structural costs are an ongoing
commitment of costs by a firm to provide capability and capacity to provide a product or
service. Discretionary costs represent process enhancements that provide additional
capability, capacity or improve efficiency. The decision when and where to invest in
process enhancements are at the discretion of management. Costs are committed to
process enhancement based on the most current set of conditions at the point in time that
a decision is made. The organization has several options in regards to discretionary cost.
Discretionary costs can be moved forward, delayed or cancelled from the firm’s
expenditure plan when conditions dictate.
Accordingly, structural costs are obligated while discretionary costs are unobligated until
some point in time that the management commits to incurring the cost. Discretionary
6
costs might become structural costs when the expenditure is committed. Discretionary
costs enable an organization to be nimble to changing conditions.
There are several natural categories of discretionary costs. Discretionary projects are
typically undertaken to improve a process’s efficiency and effectiveness. A discretionary
event is a one-off instance of a process. The firm only commits resources to the single
event. Related future events must be independently justified.
TDC = ∑ (DP + DE)
Where: DP:
DE:
discretionary projects
discretionary events
Cost behavior patterns are also reliant on the treatment of resource capacity. The decision
to purchase a resource is, first and foremost, a process decision as has been previously
discussed. Each resource has a capacity and a cost dimension. A full time labor has
approximately 2,000 available work hours per year depending on a firm’s policies. A
machine has an availability of approximately 8,700 hours (three shifts a day, seven days a
week) less maintenance and down time.
Resources are finite (most commonly integers) while consumption occur in fractions.
Capacity (Resource capacity corollary) separates resource into its used and unused
components. The veracity of capacity consumption is independent of how the cost system
treats resource capacity. The reality of process transformation is that resource
consumption is not always perfectly matched with resource availability.
The decision to purchase a resource involves a capacity decision. Capacity decisions, in
turn, are dependent on a myriad of factors including projected activity level, risk of
shortage, resource flexibility to name a few. Unused capacity is both an opportunity and a
risk. An unused resource that can be turned into a process consumed resource can create
value at a greater rate than the cost consumed. Unused capacity is an important buffer to
changing activity level.
The firm’s cost equation can be expanded to include capacity considerations.
TC = (TSCu + TSCn) + TDC
Where: TSCu: total structural cost used
TSCn: total structural cost unused
How capacity is treated by cost analytics will result in significantly different cost
behavior patterns. A cost analytic that ignore resource capacity in computing unit cost
result is influenced by both changing activity levels and process variation. The preferable
unit cost calculation is to separate used and unused capacity:
UCc = ((TSCu + TSCn)/Q) + TDC/Q
7
UCc = (USCu + USCn) + UDC
Where: UCc:
USCu:
USCn:
UDC:
Unit cost (capacity)
Unit used capacity cost
Unit unused capacity cost
Unit discretionary cost
Unit cost(capacity) separates the unit cost calculation from normal process variation. The
separation of unused capacity removes the bias caused by capacity utilization swings.
Process Economic Assumptions
There are a multitude of assumptions that underlie process economics. The key
assumptions include the following:





Process takes precedence over resources. A firm’s cost behavior pattern is most
influenced by its choice of processes and its estimate of process volume. These
decisions determine a firm’s probability of long term success or failure.
Resources are bundled together by process transformation logic. The cost
behavior of this bundle of cost is directly related to how a process functions. The
amount of resources dedicated to a process depends on the activity level (activity
level volume) and resource capacity. The commitment to a strategy entails a
commitment to provide the basic resources needed to perform the firm’s
processes.
Structural costs represent a long term commitment to provide capability and
capacity. A structural cost is one that is embedded in the process. Resource
consumption is tied to process transformation logic. Resource transformation
logic can and should be continuously improved. The goal of process improvement
is to improve process efficiency and effectiveness.
Discretionary resources are uncommitted until events warrant committing
additional resources to a process. Discretionary costs are investments in
expanding process capabilities or process improvement initiatives. Discretionary
costs are planned process costs that can be delayed or abandoned based on current
conditions that exist at a certain point in time. Discretionary costs are not
structural costs until they are committed. Discretionary costs enable an
organization to be nimble to changing conditions
Resources have a finite capacity. Capacity is either used or unused. Capacity cost
display a stepwise cost behavior. Unused capacity is converted into used capacity
until exhausted. The firm must then acquire a new unit of resource.
Implications
Process economics challenges the robustness of “truth” rather than the instance of
“truth”. Is it true that resources exhibit a fixed and variable relationship to activity
volume in the short run? Absolutely! Is it equally true that the process requires a bundle
of resources that are integral to effective process transformation? Absolutely! The
question is which view of truth takes precedence over the other. The choice rests with
8
which foundation best mirrors natural cost behavior which, in turn, leads the better
decision making. Here it is hypothesized that processes should have precedence over
resources in understanding economic behavior.
To begin, the distinction between fixed and variable is an illusion. It is often easier in
today’s internet connected world to buy or sell tangible assets than it is to layoff an
employee. Ebay, and other internet sites, offer a worldwide accessible marketplace to buy
and sell many tangible assets. High value capital assets are often leased than purchased.
Meanwhile, employee rights are codified in law and company policy. Employees can file
lawsuits if they believe their rights have been violated. The legal costs can be substantial
even when an organization prevails in the legal proceedings.
Functional and employee specialization further blur the distinction between fixed and
variable. An organization must pay a market based price to acquire the services of an
employee. The price (salary) can vary dramatically based on the education and
experience level of the person. An organization must pay a premium salary to shift a
person to a job that requires less skill. Likewise, to shift a person to a higher skilled job
typically requires incurring training and learning curve costs. Union restrictions also
inhibit worker flexibility. Any attempt to apply meaningful fixed and variable
distinctions is a slippery slope in today’s topsy-turvy world.
The fixed and variable distinction is also a psychological barrier to creating value. A
firm that bestows a “fixed” characteristic on a resource often limits the attention given to
the resource. Considering a resource as a component of a process results in improving the
entire bundle of resources—both those neoclassical economics considers fixed and
variable—as part of a continuous improvement program.
Process logic provides a much better understanding of organizational economic behavior.
There is a direct correlation between an organization’s processes and its resource
consumption. Organizations fund processes to acquire capabilities. The investment a firm
makes in capabilities should reflect the organization’s strategic priorities and represents a
committed course of action.
All resources possess a capacity component. Every resource is finite. Each
transformation cycle consumes a bundle of associated resources. What remains of the
unused resources are available for future consumption. Excess unused resources tie up a
firm’s valuable capital. Too little unused resources cause bottlenecks and lost revenue.
The challenge is to balance capacity and has been for eons. The cost behavior pattern of
firms is reflected in their successful, or unsuccessful, search for balance. The concept of
process capacity management takes precedence over fixed and variable.
A firm’s breakeven point occurs when revenues equal structural costs. A structural cost
requires significant management effort to reduce or eliminate the related cost.
Discretionary cost is a point in time decision whether to authorize the expenditure.
Organizations become more nimble organization when it is able to shift costs from
structural to discretionary.
9
Conclusion
The introduction of process economics is essential to understanding a firm’s cost
behavior patterns. A hierarchy of cost behavior begins with processes. Processes follow
from strategic decisions that reflect the firm’s commitment to provide capabilities and
capacity. Processes beget allocating structural resources to processes and committing
discretionary resources to enhancing capabilities and improving efficiency. Processes
then beget used and unused capacity. Resources must be acquired prior to performing a
process. Resources have varying amounts of capacity. Balancing process resource needs
with resource capacity is an essential role of management.
The search for a better understanding of economic cost behavior is essential to both
accountants and economists. While each branch of knowledge has its unique ways of
calculating costs, there should not be differences in understanding a firm’s cost behavior.
Such knowledge should be common to both.
Today economic theory is a collection of postulations to explain situation specific cost
behavior. Each postulation taken independently is founded on logic. However, logic can
look less logical when viewed from a different perspective. Process economics seeks to
create a common foundation between economics and accounting. Cost behavior patterns
happen. Natural laws shape the cost behavior patterns. Process economics seeks to
understand process transformational logic.
Economic theory must be translated into accounting decision tools be useful. The
decisions that are made by a firm's top management should emanate from microeconomic
logic and data. Logic that inadvertently leads managers to make mediocre decisions may
eventually prove fatal to their companies and an economy.
10