The Income Statement—Variable and Fixed Costs

January 2005

The top four concerns of business are liquidity, profitability, growth, and financing. The income statement focuses primarily on profitability and growth.

The income statement has many aliases. Some call it the P&L, some the profit and loss. Governments are so opposed to the word “profit” that they call the income statement the Statement of Revenues and Expenditures. I have also heard it called the statement of earnings.

Memorize this Formula!

What is common to all income statements—no matter what their name—is that they follow a very basic formula.

Revenues less expenses = profit

That makes perfect intuitive sense. Profit is what you have after you subtract expenses from the sales price of your item. Profit also has aliases: earnings, income, and net income.

The income statement would be so simple if we just had three numbers: revenue, expenses, and profit. But of course, we don’t stop there. We want more information. The income statement is broken down into categories and subtotaled several times before we get to the final profit or net income figure. And the subtotals are primarily focused on segregating costs into categories.

To understand the subtotals, we need to first tackle some cost terminology.

Cost Terminology

Accountants are not happy just naming something a cost. It is useful to us to categorize and subcategorize costs. The two most common ways that we discuss cost center around the way a cost behaves and the way a cost is applied. Let’s do the behavior breakdown first.

The Way a Cost Behaves

Costs can behave as variable, semi-variable, or fixed.

A fixed cost remains the same no matter how many units you produce or how many employees you have. It is stable. If we graphed it over a period of a year, it would look like this:

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A good example of a fixed cost is rent. It stays the same no matter what month it is, or how many units you produce.

A variable cost varies with something. It might vary with production or number of employees. If we graphed it over a period of a year it might look like this:

A good example of a variable cost is parts. The more stuff you manufacture, the more parts you need.

A semi-variable cost is somewhere in between. It is either fixed for a while and then jumps, like this:

or it varies for a while and then becomes fixed.

A good example of these types of a semi-variable cost is labor. If you employ six guys, you are at the bottom level. As soon as you hire a new guy, your cost jumps and stays high for a while.

Other semi-variable costs have a fixed component at its base and then varies on top of the fixed component. A good example of this is the monthly charge for electric utilities. You pay a fixed cost just to have the service turned on and then the usage changes month to month—a more variable behavior.

Now all of this is just shades of gray. A fixed cost—even rent—would look variable if you graphed it over a ten-year period. And if you compress the scale of your graph, a variable cost can look fixed.

So, what should you take away from this? There is no textbook definition of what is a fixed, variable, or semi-variable cost. When someone starts talking this lingo with you, you need to ask them to clarify what costs they are lumping into what category. I’ve had folks tell me that component costs are fixed because they are the same per unit. That is one way of looking at it, but does not take into account that you use varying amounts every day. So the caveat here is: be careful how you use and interpret this terminology.

And you thought accounting was exact and precise! Surprise!

Next month, we will talk about the way a cost is applied. This will allow us to take a critical look at the income statement.