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What is a Fixed Cost?

definition

A fixed cost is a cost that does not change based on the increase or decrease in a company’s production or sales.

🤔Understanding fixed costs

A fixed cost is one that doesn’t go up or down based on the production volume or sales performance of a company. Business expenses generally can be broken down into two different types: fixed costs and variable costs. Variable costs, sometimes called direct costs, are those that change based on the volume of products produced or services provided. We sometimes refer to fixed costs as indirect costs or overhead costs. Fixed costs don’t go up or down based on the production volume or sales performance of a company — Companies can’t avoid these costs, even in months where business is bad. The higher a company’s fixed costs, the more revenue it must typically make to break even.

example

Imagine Dan has decided to open his own restaurant called Dan’s Pancake House. Dan first secures a building where he pays monthly rent. The price of Dan’s rent is a fixed cost — No matter how many pancakes Dan makes or sells, his rent never changes. If business is good, his rent will eat up a smaller percentage of his profits. But, it also means that no matter what, Dan knows he always has to sell enough pancakes to cover the cost of the rent to break even in a given period.

Takeaway

Fixed costs are like the foundation of a house…

You can change a lot of things about a house. Increasing the number of people in the house might mean increasing the amount of furniture in the bedrooms or the amount of food in the fridge. But the foundation itself remains the same.

Tell me more...

What is included in fixed costs?
What is the difference between fixed costs and variable costs?
What is a breakeven analysis?
How are fixed costs represented on a financial statement?
What is the formula for fixed costs?
Why do fixed costs matter?

What is included in fixed costs?

Fixed costs are those that remain stable regardless of business performance. An obvious example of a fixed cost is the rent or mortgage that a company pays for its place of business.

Let’s say you run a local bookstore, and you have a monthly rent of $2,000, per the lease you sign with your landlord. No matter how successful your business is in a given month, you always have to pay your $2,000 in rent. In a month where the business is slow, you might struggle to make rent. But in a month where the business is booming, you get to enjoy your huge profit margin.

Rent is just one example of a fixed cost, there are many more. You have other fixed expenses for your workspace, such as utility costs — these might change seasonally, but in many cases won’t change drastically as a result of increased production or sales. Another fixed cost might be equipment costs or rentals.

If a company has taken out any loans, their loan repayment is also a fixed cost. Let’s say a company has taken out a loan for $20,000 for a small capital project. Not only is the monthly repayment they make a fixed cost, but so is the interest they pay on the loan.

There are also plenty of fixed costs that come with having employees. First, if you pay your employees on an annual salary rather than hourly wages, then their expense is a fixed cost. Another fixed cost that often comes with having employees is any benefits you provide that don’t change based on hours worked — think health insurance and 401(k) plan contributions.

It is likely that over time the success (or lack thereof) of the business will affect the amount you spend on employees. For example, if the company isn’t doing well, you might have to lay off workers or cut back their benefits. If the business is great, you might hire more employees. It’s important to note that these are still fixed costs.

It is still the number of employees you have that determines how much you spend, not the number of sales the business does or how productive they are each period. Unless an employee is paid hourly or piecemeal, the money you spend on them does not increase or decrease proportionately with production.

In fact, all fixed costs are likely to change at some point during the life of the company. Eventually, your landlord may increase your rent, or you’ll move to a different location. Perhaps your local government will raise property taxes, so your annual property tax bill increases. Fixed costs are not fixed forever, they just aren’t directly influenced by the production volume or number of sales the company has.

What is the difference between fixed costs and variable costs?

While the fixed costs remain the same regardless of a company’s production or sales, the variable costs are directly affected by volume. So, if the number of sales or production goes up, the variable costs go up. As the number of sales or production goes down, so do the variable costs. Variable expenses are also known as prime costs or direct costs because they are a direct result of the number of sales.

Let’s look at variable costs in terms of a handmade jewelry business. Imagine that the business sells each piece of jewelry for $20, and they pay $5 for the raw materials to make it. The money they spend on raw materials is a variable cost. If they sell 20 pieces of jewelry, variable expenses to make them are $100 ($5 X 20). If they sell 100 pieces, variable expenses are $500 ($5 X 100). Unless they get bulk discounts on supplies, their costs will always increase by $5 for every piece of jewelry they make.

Some expenses aren’t quite fixed, but they also aren’t quite variable. These are called semi-variable expenses. An example of a semi-variable expense would be one that is fixed up until a certain number of units. For instance, a company may pay its employees a certain hourly rate with the expectation that everyone will work 40 hours per week. In those 40 hours, the company can produce 1,000 units per week. During an especially busy season, perhaps sales increase to 1,200 per week. The company then has to ask employees to work overtime, and that overtime pay is a variable cost brought on by the increased production.

What is a breakeven analysis?

Companies often use their fixed costs to do a breakeven analysis. In other words, a company determines how many units they need to sell to break even. It’s an incredibly important number because it represents the bare minimum amount of business that a company must do. And if they don’t hit that number, they are operating at a net loss (meaning they’re spending more than they’re making). A company can determine its breakeven quantity with the following formula:

Breakeven Quantity = Fixed Costs / (Sales Price Per Unit - Variable Cost Per Unit)

Using this breakeven analysis might help a company to see that its fixed costs are too high and that it will have a hard time making a solid profit based on the number of units it can realistically sell. The truth is that revenue is not the same as profit, and businesses don’t start to make a profit with the first item they sell. They often have to do a lot of business just to cover their fixed costs.

If a company manages to have low fixed costs, especially in relation to other companies in its industry, it will have an easier time crossing the breakeven threshold and making a profit.

How are fixed costs represented on a financial statement?

The most common way to structure an income statement is this format: Revenue – COGS (cost of goods sold) = Gross Profit Gross Profit – Operating Expenses = Net Profit

Most operating expenses are fixed costs. This is why they are typically recorded below the gross profit line. But fixed costs are also sometimes part of COGS. For instance, imagine a business has fixed manufacturing overhead expenses, such as the lease cost of a manufacturing plant. Under GAAP (Generally Accepted Accounting Principles), this cost should be divided over the number of products produced and then assigned to COGS based on the number of units sold.

If the lease is $1,000/month and there were 500 units produced in the month, then manufacturing overhead would be assigned at a cost of $2/unit. If 300 units were sold during the month, then $600 of this fixed cost would be allocated to COGS ($2/unit x 300 units) on the income statement. The rest ($400) would be recorded on the balance sheet as part of the inventory for the period.

What is the formula for fixed costs?

You can use the following formula to find a company’s fixed costs:

Fixed Costs = Total Costs – (Variable Costs per Unit x Number of Units Produced)

For example, let’s say a company’s total costs in 2019 came to $100,000. They made 20,000 units during the year at the cost of $4 each. Their fixed cost formula looks like this:

Fixed Costs = $100,000 – ($4 x 20,000)

By using this formula, you can find that the company spent a total of $80,000 on their variable costs. By subtracting that from their total costs, you’ll find that their fixed costs for 2019 were $20,000.

Why do fixed costs matter?

The more fixed costs a company has, the more money they have to make each month to break even. In months where the business is slow, a company will see its profit margin narrow (or perhaps disappear altogether).

Fixed costs are a bigger deal in some industries than others. When it comes to sectors that have high fixed costs (manufacturing, for example), people might feel discouraged from starting a business because the barrier to entry is so high. Someone would have to put a lot of money upfront just to get started — That’s without knowing whether they’re even going to make any money.

Other industries can have incredibly low fixed costs. For example, someone starting a web design business from their home is going to have a much lower barrier to entry than someone in a capital-intensive industry. All they may need is a computer and a knowledge of web design.

For this reason, it’s important to compare the fixed costs of companies in the same industry. If you’re comparing the fixed cost ratio (the proportion of money going toward fixed costs) of a manufacturing company with a web designer, you’re going to have a skewed picture.

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