Separation of Fixed and Variable Costs

Time horizon

The time horizon is decisive when separating costs into fixed and variable costs. Costs vary in conjunction with the time horizon. This fact is suitably explained by the costs of materials, workforce, machines, and rent employed in a production firm:

o In the extreme short-term, the materials employed in the production may be the only variable costs, as this employment increases and decreases with the slightest change in production. Worker salaries, depreciation of machinery, and rent are, in the span of a few days, fixed costs, as they do not adapt to the size of production. Even workers in production companies have a few weeks notice, although day laborers do exist. The short-term production planning is also dependent on whether the goods used are storable.

o In the medium-short-term the materials employed and the production-workers' salaries are both variable costs, as long as the workers can hired or laid off with relative ease. Depreciation of machines and rent are fixed costs. These are for the most components of the minimum costs that have to be covered by the sales price - unless the product has no value if it is not sold. A product that has no value if it is not sold, has a cost of 0 DKK when it is to be sold. The late owner of the travel agency Spies said: "Even if we only get 1 DKK for the last seat to Mallorca, it's better than an empty seat."

o In the medium-term, materials employed, production-workers' salaries, some administrative workers' salaries, and depreciation are considered variable. This is the case, as long as the machines can be sold at the depreciated value. Rent is a fixed cost.

o In the long-term all production factors are variable, e.g. interest is variable to the extent that the rent can be adapted to the size of production by simply moving the production to either larger or smaller facilities, depending on the production level. Fixed costs turn into opportunity costs, i.e. the cost of alternatively employing production factors, such as rent and equity.

The time horizons listed above are dependent on the firm and the business sector; thus they are relative.

E.g. companies can change all factors of production in conjunction with different time horizons. This flexibility means that the long-term is relative:

o For a window cleaning firm, possibly under one year

o For a taxi firm, possibly 1-2 years

o For a bus haulage contractor, possibly 2-3 years

o For pizza shop, possibly 3-4 years

o For a food product firm, possibly 8-10 years

o For a sugar factory, possibly within 15 years

o For a car manufacturer, possibly within 15 years

The other time horizons: extremely short-term, medium-short term, and medium-term, will then adapt to the long-term definition.

As will be apparent from cost theory later on, costs are traditionally and fundamentally, without regard to the decision issue to be solved, divided into short-term and long-term, which are defined as follows:

o Short term, where at least one factor of production is considered a fixed cost. This could be rent or office employees' (white collar) salaries, that cannot be changed within the time horizon because of giving notice requirements.

o Long-term, where all factors of production (workforce, capital etc.) are variable, which means that they can be phased out within the time horizon.

One of the motivations for text is the facilitation of understanding that such a separation always has to be seen in relation to the relevant decision-making situation. No matter how crystal clear this separation is, the reasons for decision-making must be analyzed before this distinction can be realized.

There exists a group of theories which are only applicable to the short-term, and another set of theories that only apply in the long-term. Of course there are a number of terms and techniques that apply in both long-term and short-term cases. Consequently, the time horizon is a decisive determinant for the specific decision-making occasion and it is fundamental that the time horizon is applied consistently.

Furthermore, it is important to be aware that mostly firms decide on the short-term and long-term simultaneously; e.g. if the management in a minor retail chain plans the pricing strategy for the next year, while simultaneously a reaction to the competitors' "birthday-promotion" has to be laid out for the following week.

Regarding the time horizon, the main point is that it is necessary to remain focused and constantly attentive to the applicable time horizon.

Different time horizons and decision-making situations result in different costs for the same production. No wonder costs theory is difficult.

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