Mixed costs are a more advanced business concept. Mixed costs refer to a combination of both a fixed and variable component. A common error made by most small business entrepreneurs is the misapplication of the formula. Many small business owners understand the textbook definition but rarely exercise the concept in reality. This article is written to introduce the term, explain the textbook definition and its primary application. Finally I’ll finish up with the realistic approach to exercising this concept in the real world of small business.
Before you begin you need to make sure you fully grasp the two underlying elements of mixed costs. Mixed costs are based on fixed and variable components. If you need some help to fully understand these two terms then please read the following articles on this website:
If you look at your cell phone bill in detail, you will notice the two elements of costs on the bill. Most cell phone bills have a fixed component, effectively the limitations built into the plan, and then the variable items. Since the variable component changes from one period to the next dependent upon use (extra data consumption, too many texts or minutes, government surcharges, etc.) the total amount of the bill fluctuates from month to month.
Well, in business, you will see the exact same concept existing in the costs you pay from one accounting period to the next. A good example is payroll. If you are involved in production and guarantee your employee a 40 hour work week then when your employee works their 40 hours that week, you have a fixed cost. It is simply the time of 40 hours multiplied by the employee rate. But the minute that employee goes over 40 hours, you have a mixed cost occurring. Now the cost for the 41st hour has a fixed component of the employee’s hourly rate, but in addition, there is a variable amount directly tied to the company’s overtime multiplier. If the company pays time and half, the 41st hour variable cost is the one half rate amount.
This appears to complicate matters doesn’t it? Think about it for a moment, we have fixed, variable and now mixed costs. The answer is yes and no. But before I address this, you will need to understand the textbook application and use.
Textbook Definition and Use
Mixed cost is a term mostly used in managerial accounting. For those of you not familiar with managerial accounting, it is the type of accounting most directly related to production based operations. Basically, managerial accounting is the preferred form in manufacturing. The goal of managerial accounting is to identify the overall cost of production per unit of manufacturing. From there, management tools are implemented to monitor and reduce the cost per unit made. These tools include monitoring the throughput, implementing control reports and operating within your range of production.
The key is that each unit produced has two primary costs. One is fixed in nature and the other is variable. The fixed costs include rent, utilities, storage, equipment and insurance. The variable costs to produce the unit are mostly labor and materials. When that unit is finally produced, it has both components in it and this is referred to as the mixed cost of production. But it goes a lot further. Often the cost of production is much more complicated because there is much more to producing and getting the product to market. Think of all the folks and tools involved in delivering something as simple as produce to the grocery store.
When you are in the produce section and you pick up that head of lettuce, have you ever wondered what it takes to get it there? There’s the farming aspect (which is comprised of both fixed and variable costs), there is the actual harvesting process (again, both variable and fixed costs), storage, packing and then distribution. The entire process has highly evolved over the last 100 years from the old format of the farmer’s market.
It would appear practically impossible to calculate the total fixed and variable costs from start to end. But it is actually done. To quantify the total costs, the law of large numbers is used (actuarial science) and business is able to determine these costs. The key is LARGE NUMBERS. Mixed costs are easy to determine and take advantage of when the matter concerns large values. At the minutia level, the value attributable to mixed costs is almost negligible. For you, the question is more in the arena of ‘How do I use mixed costs to my advantage?’ Let’s find out.
Realistic Application in Small Business
Whether you provide a service or sell a product to the ultimate customer, both types of units have mixed costs involved. As a small business owner or manager, you need to identify the fixed and variable costs involved in your operation. Once you have completed this step you then can begin to identify the mixed costs to deliver the service or product. To illustrate this, I’m going to use a carpet cleaning operation.
- Vans Labor
- Mounts Cleaning Agents/Supplies
- Warehouse Rent Utilities
- Washers/Dryers Taxes & Licenses
- Racks Office Supplies
- Insurance Repairs/Maintenance
- Jim’s Salary Fuel (Mounts and Vans)
- Professional Fees Franchising/Membership Fees
Think about the mixed costs of operations; mixed costs are the combination of fixed and variable. For Jim, his final service is comprised of both costs. To deliver a nice clean carpet, the technician uses the van to get there, turns on the mount, sprays the cleaning agent and then begins the process of cleaning the carpet and finishes by rinsing and vacuuming the excess moisture.
Jim manages the crew and his front office took the phone call and scheduled the work. Jim borrowed money from the bank to buy the van and mount and pays interest on the debt each month. In addition, to get the customer, he uses multiple forms of advertising and communication.
Overall, Jim’s fixed costs approximate $12,300 per month. Look at the list above under the fixed column. Variable costs adjust based on the volume of work. The key variable costs in descending order are labor, cleaning supplies, fuel and taxes/licenses. Jim’s contribution margin [(Sales less (Labor, Cleaning Supplies, Fuel & Franchise Fees) on the average job is around 46%. To cover fixed costs, Jim needs around $26,800 per month in sales (Fixed Costs/Contribution Margin). Jim needs an additional $6,000 per month in sales to cover the variable costs associated with the front office (Office Payroll, Utilities, Taxes/Licenses, Office Supplies, R&M). In the aggregate, Jim wants more sales to cover profit, business cycles and risk. Finally, Jim wants additional sales to generate cash to reduce debt and generate a reserve. To successfully complete all of this, sales have to exceed $40,000 per month.
OK, so what does all this have to do with mixed costs? For Jim to make a profit he has to have both fixed and variable combined as mixed costs value to finally determine the approximate percentage per dollar of sales that will be his profit. For those of you interested, the technical formula is as follows:
Sales to Cover Mixed Costs:
- Sales to Cover Fixed Costs (FC) of $12,300 = Sales – Variable (Labor, Cleaning Supplies, Fuel, & Franchise Fees) – a.k.a. Direct Contribution Margin PLUS
- Sales to Cover Other Variable Costs (Overhead Costs) = Variable Costs Divided by Contribution Margin of 46%
Using this information, if the non-production related variable costs in the accounting period are $7,220 (repairs and maintenance were high), then the formula is as follows:
Sales = FC Coverage ($12,300/.46) plus Overhead Coverage $7,220/.46, which equals $19,520/.46, which equals $42,434. The $42,434 is referred to as the Corporate Sales Break-Even Point.
Therefore, every dollar of sales after $42,434 generates 46 cents of profit. If Jim had $50,000 of sales that month, he would generate a profit of $3,480 (($50,000 in sales less $42,434 company break-even point) *.46 contribution margin).
Mixed costs is a formula that is more usable with larger values. To prove this, let’s think about the minutia involved in determining the mixed costs for a single carpet cleaning job:
- How do you allocate out the fixed costs to a single job? If only one job in the entire month, then unless this job is to clean the carpets at the Pentagon, you are not going to have sales of $42,434. Thus, fixed costs are a flat value and mixed costs changes over the volume of sales.
- It is more than likely that one of the variable costs in our formula has a fixed element and a variable element. Think about office supplies such as the forms. The printer says that the first 500 forms are a flat $30 but any batches of 500 after the first 500 are a marginal $17 per set contingent that they are printed as one large batch. Notice how the first 500 forms are fixed and the variable relates to next sets of 500 each. This is an example of mixed costs within one of the groupings of costs. Very similar to the cell phone bill I used in my Introduction above.
Conclusion – Mixed Costs
Mixed costs are often associated with manufacturing or production. The reason is that we are spreading many different types of fixed and variable costs over a large volume of widgets produced or service rendered. By using actuarial science, we have a high level of confidence that the formula is accurate because it tends towards greater accuracy as the volume of allocation increases (larger production runs). In the small business environment, it is best to think of mixed costs as the totality of all the different types of expenses the operation encounters. These include the traditional fixed expenses and those variable costs directly related to production (labor and materials). In addition there are still more variable costs usually associated with overhead types of expenses. Unless your business has a large production base whether in product or via service, it is wise to use mixed costs in looking at the aggregated picture as the carpet cleaning business example illustrates. Act on Knowledge.
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