Question

The salaries paid to people who are in the middle of three-year guaranteed contracts are _____. a) a fixed cost b) a variable cost c) a fixed cost or a variable cost d) neither a fixed cost nor a variable cost

Short answer

The salaries paid to people who are in the middle of three-year guaranteed contracts can be classified as fixed costs, as they remain constant regardless of the level of production or sales. Therefore, the correct answer is option (a) a fixed cost.

Step-by-step solution

Definition of Fixed Cost

A fixed cost is a cost that does not change with the level of production or sales. It is also described as a cost that remains constant, regardless of the firm's activity level.

Definition of Variable Cost

A variable cost is a cost that changes along with the level of production or sales. It increases as the level of output increases and decreases as the level of output decreases.

Identifying Salaries as Fixed or Variable Cost

Now, let's consider the salaries paid to people who are in the middle of three-year guaranteed contracts. Since these contracts are guaranteed, it means the salaries paid to the employees remain the same regardless of the level of production or sales. As a result, it seems that these salaries have the characteristics of fixed costs.

Selecting the Correct Option

Based on our analysis, we can conclude that the salaries paid to people who are in the middle of three-year guaranteed contracts can be classified as fixed costs. Therefore, the correct answer is option (a) a fixed cost.

Key concepts

Variable Costs

Variable costs are expenses that change depending on how much a company produces or sells. The more items you produce or sell, the higher these costs get. Conversely, if production decreases, the variable costs decrease as well.
Variable costs are directly proportional to production levels. Think of them like fuel for a car: the more you drive, the more fuel you need. Examples include costs of raw materials, direct labor (like hourly wages), and utility costs based on consumption.
To calculate variable costs, you multiply the cost per unit by the number of units produced. For instance, if it costs $5 in materials to make one product, and you make 100 of them, your variable cost is $500. This straightforward relationship makes it easy to see how changes in production affect these costs.

Contract Salaries

Contract salaries refer to the payments made to employees who are under a fixed-term agreement. Such contracts often guarantee payments for a specific duration of time—like one or three years—regardless of the company’s level of production or revenue.
These salaries differ from hourly wages. While hourly wages fluctuate with the hours worked, contract salaries stay constant, much like a subscription fee that stays the same regardless of usage.
When we consider three-year guaranteed contracts, these payments are considered fixed costs. This is because the salary obligation remains unchanged irrespective of the business's production levels. Understanding this distinction is crucial for assessing financial stability and planning future budgets.

Production Level

Production level refers to the quantity of goods or services produced by a company during a specific period. Managers pay close attention to production levels as they directly influence both costs and revenues.
The production level impacts variable costs significantly: higher production increases variable costs, while lower production decreases them. Fixed costs, on the other hand, generally remain constant regardless of production levels, like facility rent or those contract salaries.
To optimize production levels, businesses often analyze market demand, resource availability, and cost structures. By scrutinizing these factors, companies aim to find the sweet spot where production is high enough to meet demand and cover costs, yet efficient enough to maximize profit.