Variable Cost-Plus Pricing

And finance Allah Shmoop What are the four types of

costs Oh all right Well lots of things come in

fours legal's the horsemen of the Apocalypse and Stooges you

know don't forget ship Okay so in practical reality these

concepts actually matter how so Well think about your personal

budget The one you used to direct your day to

day expenses There are four universally accepted types of costs

for a regular person's budget rent Internet burritos and yes

video games Now think about a company As with your

budget well there are four types of costs that a

company has to consider the categories air well slightly different

though generally speaking of business has to keep in mind

these four kinds of expenses fixed variable semi variable and

step The categories correspond to how much the cost changes

When the amount of output changes you increase the amount

of stuff you make Well how much did that cost

change Not at all Well then it's a fixed cost

The cost changes proportionally with every increase in production Well

then that's a variable cost somewhere in between wealth And

that's semi variable or step Well you own a factory

that makes toothpicks for Gap tooth people made from exotic

hardwoods It's called the Dunaway Letterman Jack O Lantern company

Tough to fit on a mug but well you like

it You make one hundred thousand box of toothpicks a

month and you want to ratchet that number up to

one hundred twenty thousand boxes a twenty percent bump Well

how will the increased production effect costs Well the actual

cost will respond differently It depends on what category they

fit into Will all of the costs go up twenty

percent with this increase in production Yeah probably not Meaning

the company will scale You'll produce more and you'll have

higher profits So quick tour Here we go Fixed costs

don't change at all They stay the same no matter

how much you make that is fixed Like the toothpick

grinding floor the sawdust sucking system the factory building itself

fifty thousand units eighty thousand units a hundred thousand units

that fixed cost is all the same If you decided

to make eighteen million units Well then things would be

different But at this scale or this level it's all

fixed It's all the same The only big notable difference

is that the fixed costs and of the factory is

now amor ties over a larger number That is if

it cost twenty grand a month to rent that factory

and all the equipment in it If you made twenty

thousand toothpick boxes a month while the fixed cost per

box would be a buck if you made two hundred

thousand creep pick boxes in a month we'll then the

fixed cost per box would be a dime right That's

fixed It doesn't change month after month after month as

it Rikers and you basically save money when you have

big volume output Because the cost per fixed foot is

a flat variable costs are directly linked to the amount

of output Factories making and variable you know varies well

The increase in cost here is pro pie fortune All

make one more to thicken the variable cost increase accordingly

Why Well because you have to buy more raw wood

supplies to put through the system you have to run

the saws longer You have more sawdust to clean more

packing material to by someone Someone more Output demands more

input So think high brand fiber food something like that

okay Next semi variable costs have elements of fixed and

elements of variable costs Usually they have a fixed component

and a variable component like the electricity to run the

machine that puts the little plastic flew fi things at

the end of the toothpicks Turning it on takes a

certain amount of baseline electricity That part is fixed but

then running the machine takes a little extra electricity for

each flukey thing that gets installed That part is variable

so the cost of running the machine gets thrown into

the semi variable group A little bit fixed and a

little bit variable Got it Alright last category step costs

these increase in levels or scale The increase isn't proportional

as with variable cost but instead takes place in steps

like step cost might stay the same One output rises

from one hundred thousand to one hundred twenty thousand boxes

but then the one hundred twenty thousand and first item

causes the step cost to bump up The cost jumps

up in chunks and it stays the same for a

while But then a certain point moves it to a

higher level like you need a scale box Packer or

you need some other thing that handles ten thousand maur

twenty thousand fifty thousand more boxes because that's a whole

different scale set of demands than if you were just

packing a few hundred boxes You could do those manually

You don't need the high tech robots then to do

it right So it stayed same for a while as

a staff and then it reaches another production point and

then costs kind of zoom up well breaking down a

little more detail fixed Think Brent your toothpick factory cost

ten thousand month and rent It cost that much If

you meant no toothpicks it cost that much If you

make a thousand boxes of toothpicks and a cost that

much If you make one hundred thousand box of toothpicks

that rent is fixed it doesn't change To get the

most out of a fixed costs You want to make

his many things as possible As many Turbo Whittle five

thousand machines is you could fit into the factory Maximizing

volume production allows you to get the most out of

those fixed costs of rent per dollars spent Okay you

spent ten thousand dollars rent to make one toothpick while

that becomes a really expensive to pick right You have

to find someone to pay at least ten thousand dollars

for it plus all the other costs related to making

that one little wood sliver but make ten thousand or

one hundred thousand boxes of toothpicks and your rent expense

Well then is only a ten cents a box right

Next type variable The type of expense increases proportionally without

put raw material expense is a good example Each toothpick

needs so much African black wood or South American cedar

Yeah say you need three dollars worth of African black

wood to make ten boxes of toothpicks Still making one

box would cost thirty cents Making ten boxes will cost

three bucks and making one hundred thousand will cost thirty

grand and making one hundred thousand one boxes will cost

thirty thousand and three dollars of the African Blackwood stuff

right Because the same cost and no matter what volume

you order the cost goes up in what's called a

linear progression A straight line on a graph Labor can

also work this way but it depends on how you

pay your workers Pay them on a per piece basis

And it's completely variable Bob Splinter gets paid a penny

for every toothpick he makes He makes a thousand toothpicks

He gets a ten box He makes two thousand five

hundred twenty three toothpicks He gets twenty five dollars twenty

three cents It's completely variable but Bob joins the Toothpick

makers local one forty two Their contract calls for an

hourly wage twenty five dollars an hour Plus Bob is

guaranteed forty hours a week Well now his wages aren't

fixed at a grand A week there It doesn't matter

how many toothpicks he makes in an hour Bob gets

the same amount no matter what So if you can

get more efficient with production if you can figure out

how to make more per hour we'll then you Khun

Stretch the labor cost Mohr Just as with the rent

costs while you're proportional per unit cost will go down

the more you make in the same amount of time

on two semi variable elements of both fixed and variable

cost Think about the pay for a sales person with

a fixed salary of fifty grand a year to your

sales associate You also give them a bonus of two

dollars per ten boxes sold So each additional ten box

units sold carries a two dollars variable cost to you

related to commission But the salary is a fixed cost

It gets relatively less expensive per unit with each additional

sail Right You're going to pay fifty grand no matter

what if the sales person sells ten boxes in a

year Well the sales cost for that unit is fifty

thousand two dollars The full salary plus the two dollar

commission yet really expensive Yeah You just pay the salesperson

five thousand dollars in twenty cents for each box of

toothpicks they sold Yeah that was a bad deal If

they sell ten thousand boxes will Now the overall cost

is fifty two thousand for the year fifty grand in

salary and two grand for the total commission for those

thousand units Your paying Mohr on an absolute basis but

the per box amount is much better now You pay

just five twenty per box Okay so let's look at

the big winnings Compensation for one hundred thousand boxes sold

in a year Total cost goes up to seventy thousand

again Maurin Absolute basis Fifty thousand salary twenty thousand Commission

But now the per box costs just seventy cents Lastly

there's the step category Instead of a per unit commission

you offer your salespeople a bonus when they hit a

certain level If they sell a hundred thousand units they

get a twenty thousand dollar bonus So sales one through

ninety nine thousand nine hundred ninety nine while the sales

person earns fifty grand for the year on sale number

one hundred thousand They earned seventy thousand for the year

fifty grand in salary And you know the twenty grand

bonus that hundred thousand sail becomes very expensive for you

may be worth it to incentivize your sales force though

so you gotta think about that stuff But because of

the structure of strategy surrounding step costs are often different

than the other three categories Right Did you get that

big step function when they hit their next level of

bonus For each of the other categories it's better to

make output as high as possible Or in the case

of variable costs it's at least neutral Assume you sell

everything you make and that making tons of stuff doesn't

force prices down Well then given your ability to sell

everything and maintain pricing levels It's more profitable to make

a cz much as possible with fixed and semi variable

costs for each of those categories the per unit cost

goes down with each additional toothpick you make The per

unit cost of variable expenses states the same but it

doesn't cost any more at least on a relative basis

to make more So why not make more especially as

you're fixed and semi variable cost get relatively cheaper Is

output increases right Well step costs work differently as you've

seen there Khun B scenarios where it's more profitable to

not go to that next step and hopefully not have

to pay all those bonuses You Grinch In the case

of the sales bonus that hundred thousand unit comes with

a twenty thousand dollars sales price tag meaning that big

bump in commission to your sales force Well it might

be best just to make ninety nine thousand nine hundred

and nine boxes and call it a day But then

when the clock resets on the bonus well then you

start again at one sale Staff will not be happy

but well that one time you could save twenty grand

bonus and good luck with that That's not how the

real world works Is that bonus money worth a hostile

work environment create Yet Not for us to say You'll 00:09:30.462 --> [endTime] have Tio you know pick your own battles