What Is a Fixed Cost?
A fixed costis a business expense that normally doesn’t change with an increase or decrease in the number of goods and services produced or sold by the business.
Fixed costs are commonly related to recurring expenses not directly related to production, such as rent, interest payments, insurance, depreciation, and property tax.
Since fixed costs are unrelated to a company’s production of goods or services, they are generally indirect costs. A fixed cost is one of two different types of business expenses that together produce total cost. The other is a variable cost.
Key Takeaways
- Fixed costs are expenses that aren't related to a company's operational activities.
- They are set for a specified period and do not change despite a change in production levels.
- Fixed costs can be direct or indirect and may influence profitability at different points on the income statement.
- Unlike a fixed cost, a variable cost is directly associated with production and may change based on output.
- Fixed costs can be used to calculate key metrics, including a breakeven analysis or a company's operating leverage.
:max_bytes(150000):strip_icc()/TermDefinitions_Fixedcost-262ceb69354340e7a8bbd1c05adb3771.jpg "Fixed Cost: What It Is and How It’s Used in Business (1)")
Understanding Fixed Costs
Fixed costs don’t change with production levels. Also referred to as fixed expenses, they are usually established by contract agreements or schedules. These are the base costs involved in operating a business. Once established, fixed costs do not change over the life of an agreement or cost schedule.
Fixed Costs on Financial Statements
Fixed costs are allocated in the indirect expense section of the income statement, which leads to operating profit. Depreciation is a common fixed expense that is recorded as an indirect expense. Companies create a depreciation expense schedule for asset investments with values falling over time.
For example, a company might buy machinery for a manufacturing assembly line that is expensed over time using depreciation. Another primary fixed and indirect cost is salaries for management.
Any fixed costs on the income statement are accounted for on the balance sheet and cash flow statement. Fixed costs on the balance sheet may be either short- or long-term liabilities. Any cash used to pay fixed cost expenses is shown on the cash flow statement.
In general, the opportunity to lower fixed costs can benefit a company’s bottom line by reducing expenses and increasing profit.
Factors Associated With Fixed Costs
Companies examine fixed (and variable) expenses when analyzing costs per unit. As such, the cost of goods sold (COGS) can include both types of costs. All costs directly associated with producing a good are summed collectively and subtracted from revenue to arrive at gross profit. Cost accounting varies for each company depending on the costs with which they work.
Economies of scale can also be a factor for companies producing large quantities of goods. Fixed costs can contribute to better economies of scale because they can decrease per unit when larger quantities are produced. That is, per-unit fixed costs drop when they get spread out over a larger number of units.
Fixed costs that may be directly associated with production will vary by company but can include costs like direct labor and rent.
Companies have some flexibility when breaking down costs on their financial statements, and fixed costs can be allocated throughout their income statement. The proportion of fixed to variable costs (and how they're allocated) can depend on its industry.
Examples of Fixed Costs
Fixed costs includeany number of expenses, including rental and lease payments, certain salaries, insurance, property taxes, interest expenses, depreciation, and some utilities.
For instance, someone who starts a new business would likely begin with fixed expenses for rent and management salaries.
All types of companies have fixed-cost agreements that they monitor regularly. While these fixed costs may change over time, the change is not related to production levels. Instead, changes can stem from new contractual agreements or schedules.
Fixed Cost vs. Variable Cost
Fixed expenses are usually negotiated for a specified period but can't decrease on a per-unit basis when they are associated with the direct cost section of the income statement, fluctuating in the breakdown of costs of goods sold.
Unlike fixed costs, variable costs are costs directly associated with production. Therefore, they change depending on business output. These costs can increase or decrease relative to production levels or sales.
When production increases, variable costs rise. When production decreases, these expenses drop. Variable costs also vary by industry, so it's important for anyone analyzing companies to make comparisons between those that are in the same industry.
Examples of variable costs include the cost of labor, utilities, raw materials, shipping costs, and commissions.
| Differences Between Fixed Costs and Variable Costs | ||
|---|---|---|
| Fixed Costs | Variable Costs | |
| Do They Change? | Sometimes | Often |
| Based on Production | No | Yes |
| Direct or Indirect | Generally indirect | Generally direct |
| Examples | Rent, interest, insurance, depreciation, property tax | Labor, utilities, raw materials, shipping, commissions |
Another type of expense is a hybrid between fixed and variable costs. Semi-variable costs are composed of fixed and variable components, which means they are fixed for a certain production level. After this threshold, the costs become variable. Some of the most common examples of semi-variable costs include those for repairs and electricity.
Special Considerations
Fixed expenses can be used to calculate several key metrics, including a company’s breakeven point and operating leverage.
Breakeven Analysis
A breakeven analysis involves using both fixed and variable costs to identify a production level at which revenue equals costs. This can be an important part of cost structure analysis. A company’s breakeven production quantity is calculated by:
BreakevenPoint=SPPU−VCPUFixedCostswhere:SPPU=SalespriceperunitVCPU=Variablecostperunit
A company’s breakeven analysis can be important for decisions that must be made about fixed and variable costs. The breakeven analysis also influences the price at which a company chooses to sell its products.
Operating Leverage
Operating leverage is a cost structure metric used in cost structure management. Companies can generate more profit per additional unit produced with higher operating leverage.
The proportion of fixed to variable costs influences a company’s operating leverage. Higher fixed costs help operating leverage to increase. You can calculate operating leverage using the following formula:
OperatingLeverage=(Q×(P−V))−FQ×(P−V)where:Q=NumberofunitsP=PriceperunitV=VariablecostperunitF=Fixedcosts
Cost Structure Management and Ratios
In addition to financial statement reporting, most companies closely follow their cost structures through independent cost structure statements and dashboards.
Independent cost structure analysis helps a company fully understand its fixed and variable costs and how they affect different parts of the business, as well as the total business overall. Many companies have cost analysts dedicated solely to monitoring and analyzing a business's fixed and variable costs.
The fixed charge coverage ratio, on the other hand, is a type of solvency metric that helps analyze a company's ability to pay its fixed-charge obligations. The fixed-charge coverage ratio is calculated with the following equation:
FixedChargesBeforeTax+InterestEBIT+FixedChargesBeforeTax
The fixed cost ratio is a simple ratio that divides fixed costs by net sales. It's used to determine the proportion of fixed costs involved in production.
Are All Fixed Costs Considered Sunk Costs?
All sunk costs arefixed costs in financial accounting, but not all fixed costs are considered to be sunk. The defining characteristic of sunk costs is that they cannot be recovered.
How Are Fixed Costs Treated in Accounting?
Fixed costs are associated with a business's basic operating andoverhead costs. Fixed costs are considered indirect costs of production, meaning they are not costs incurred directly due to the production process, such as a cost for parts needed for assembly. However, they do factor into total production costs. As a result, fixed costs are depreciated over time instead of being expensed.
How Do Fixed Costs Differ From Variable Costs?
Unlike fixed costs, variable costs are directly related to the cost of production of goods or services. Variable costs are commonly designated asthe cost of goods sold (COGS), whereas fixed costs are not usually (but can be) included in COGS. Fluctuations in sales and production levels can affect variable costs if factors such as sales commissions are included in per-unit production costs. Meanwhile, fixed costs must still be paid even if production slows significantly.
The Bottom Line
A fixed cost is one type of business expense. The other type is a variable cost. Fixed costs are expenses that do not change as production levels change. Rent is one example of a fixed cost. Unlike fixed costs, variable costs (e.g., shipping) change based on a company's production levels.
