What Is a Fixed Cost?
Fixed costrefers to a business expense that doesn’t change even with an increase or decrease in the number of goods and services produced or sold. 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. Shutdown points tend to be applied to reduce fixed costs. These costs are among two different types of business expenses that together result in their total costs. The other is called a variable cost.
Key Takeaways
- Fixed costs are expenses a company must pay outside of its operational activities.
- These costs are set over a specified period and do not change with production levels.
- Fixed costs can be direct or indirect and may influence profitability at different points on the income statement.
- Unlike fixed costs, variable costs are directly associated with production and may change based on output.
- Fixed costs can be used to calculate key metrics, including the 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 are those that 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 comprehensively. Once established, fixed costs do not change over the life of an agreement or cost schedule.
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. Finally, any cash paid for the expenses of fixed costs 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.
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 vs. variable costs a company incurs (and how they're allocated) can depend on its industry.
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 portion 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 with respect to production levels or sales. When production increases, variable costs rise. Similarly, when production drops, these expenses end up dropping. These costs also vary by industry, so it's important for anyone analyzing a company to make comparisons with those that are in the same sector.
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 |
Factors Associated with Fixed Costs
Companies can associate 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. Fixed costs that may be directly associated with production will vary by company but can include costs like direct labor and rent.
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 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 in 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 on 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 another cost structure metric used in cost structure management. 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
Companies can produce more profit per additional unit produced with higher operating leverage.
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 from the following equation:
FixedChargesBeforeTax+InterestEBIT+FixedChargesBeforeTax
The fixed cost ratio is a simple ratio that divides fixed costs by net sales to understand the proportion of fixed costs involved in production.
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.
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 by the production process, such as 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 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
Fixed costs are one of two types of business expenses. The other is variable costs. Fixed costs are expenses a company pays that do not change with production levels. Rent is one example. Unlike fixed costs, variable costs (e.g., shipping) change based on the production levels of a company.
