Fixed and Variable Costs: When Accounting Is the Opposite of Cash Flow Reality

DOIhttp://doi.org/10.1002/jcaf.22158
Published date01 May 2016
Date01 May 2016
31
© 2016 Wiley Periodicals, Inc.
Published online in Wiley Online Library (wileyonlinelibrary.com).
DOI 10.1002/jcaf.22158
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Fixed and Variable Costs: When
Accounting Is the Opposite of Cash
Flow Reality
Reginald Tomas Lee
My job as a
business exec-
utive advisor
and researcher is
to help people see,
understand, and
manage cash flow
more effectively. As
an engineer, I was
never tied to the rules
and constraints of
accounting when
modeling cash flow.
Instead, I focused on what
made sense logically and math-
ematically. This has led to a
number of points of view that
tend to challenge traditional
accounting principles. One such
topic is the notion of fixed and
variable costs.
Fixed and variable costs
are key themes to understand
when analyzing the dynam-
ics of costs. Fixed costs are
defined from an accounting
perspective as costs that do not
change with output such as
rent. Variable costs do change
with output from an account-
ing perspective. Labor involved
with manufacturing a product
or performing a service may be
considered variable costs.
When I speak to companies
for whom fixed and variable
costs are important consider-
ations in managing their costs,
I’ve noticed accounting has
these ideas wrong in some cases
and completely backwards in
others when considered in the
context of cash flow.
As foundation,
consider two people
doing the same job
answering customer
service calls. You pay
one $0.50 for each
call they answer. As
you can see from
Exhibit 1, the money
paid out increases
with the number
of calls the person
makes. This cost
varies with output, so it may
be considered a variable cost.
Compare this to someone sit-
ting next to him who is making
$10 per hour doing the same
work. Exhibit 2 shows there is
no change in cash being paid
based on output, so it is not a
variable cost from an output
perspective.
In this situation, you have
two people sitting next to each
other doing the same job. One
cost varies with output and the
other does not. However, an
accounting analysis may sug-
gest that they are both direct
costs and, therefore, variable
There are three things you will need to consider
when seeing, understanding, and managing fixed
and variable costs. First, you need to recognize
whether the costs under consideration are cash or
noncash costs. Second, you need to understand how
and why the costs vary. And third, the implications
of having costs that vary are all important to
managing cash flow effectively. © 2016 Wiley Periodicals, Inc.
This is the second in a series of
articles in which the author will share
ideas that will help you see you orga-
nization much more effectively from
capacity and cash flow perspectives.
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