What Is Fixed Cost and What Is Its Business Application?

By Indeed Editorial Team

Published 3 April 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Fixed cost is an integral part of a company's expense calculations and refers to costs that don't change. Regardless of the business activities during a certain time period, companies still pay fixed costs. Learning about what goes into the calculation of fixed costs and why they're important for the business can help you understand more about the financial situation of a company. In this article, we explore the definition and examples of fixed, explain how they can benefit a business and list fixed cost calculations.

What is fixed cost?

Learning the answer to "What is fixed cost?" and how it differs from variable cost can help you understand more about a company's expenses and reduce the overall costs. A fixed cost is a company's expense that stays constant regardless of the production volume. These are the costs that would still come up even if executives temporarily stop the production. The primary examples of fixed costs include rent, insurance payments and salaries.

Variable costs directly correlate with business activities and fluctuate from one period to another. These costs are more challenging to monitor and predict as the production volumes might change. A seasoned accountant knows methods of forecasting future variable costs, which can help prevent these challenges. Examples of variable costs include taxes, commissions and operational expenses.

Related: What Are Compensation and Benefits? Definition and Importance

Examples of fixed costs

To gain a deeper understanding of fixed costs, you can explore some of the most common examples:

  • Depreciation: Depreciation refers to a value reduction of a tangible asset such as machinery, buildings and equipment over a certain period. Accountants write off a certain constant amount over the useful life of an asset at the end of each period.

  • Amortisation: Amortisation is also a gradual loss of value, but it refers to intangible assets such as patents. For example, a patent costs $20,000 and expires in 10 years, and, in this case, the amortisation charge is $200 every year before the patent loses its value.

  • Insurance: Insurance is an arrangement that guarantees some level of compensation for various types of losses and damages to the equipment and injuries to employees. Under the insurance contract, you pay a fixed cost regardless of the production volume and business operations.

  • Rent: Rent is another fixed cost that does not fluctuate and remains constant irrespective of the company's performance or sales revenue. In a company, rent could refer to warehouses, office spaces, garages, storage units and any other premises that belong to a third party.

  • Interests: Most business owners received loans to launch their products with the initial capital. If a company takes out a loan or accumulates debt, they pay monthly or early interests regardless of any other key metrics.

  • Property taxes: Based on the regulations of the location and costs of assets, every company pays property taxes. These vary from business to business but remain constant at any given period unless a company acquires more property.

  • Salaries: Salaries are also monthly fixed expenses that do not change depending on how well the business goes. Even if a company closes down for a limited period, paying out salaries remains an obligation.

  • Utilities: Utilities include phone and internet bills, electricity, gas, water and other common expenses that occur each month. They might be small but essential services every business uses regardless of the company's performance.

  • Legal: Legal expenses refer to any proceeding and regulations created by an internal or external legal team. Legal fees remain constant and thus fixed due to negotiations in advance, and it's common to include them in the contracts before proceeding with any legal services.

Related: Salary vs. Wage: What Are the Advantages and Disadvantages?

Benefits of fixed costs

Here are a few benefits that a company can gain from calculating and monitoring fixed costs:

They remain stability

Fixed costs remain constant regardless of the company's performance or production volume. For example, once a company has purchased and set up a machine, production costs stay the same. This is why fixed costs are easier to calculate and monitor as an increase or decrease in production volumes has no effect. While variable costs fluctuate depending on various production-related factors, fixed costs usually remain stable.

Per-unit costs can decrease

Although fixed costs mostly stay the same, in certain situations, per-unit costs can go down. For example, say you own a production machine with a value of $1,000 and manufacture 1,000 chocolate bars at every given period. The costs per unit in this scenario are $1. If you change the volume and begin producing 2,000 chocolate bars using the same machine, the per-unit costs decrease to $0.50.

They're predictable

If a company remains within a certain range of production output that the equipment can handle, fixed costs are usually easy to calculate and predict. Compared to variable costs that fluctuate based on numerous factors, some of which are external and unpredictable by nature, fixed costs provide a level of security. Predictability in business is an immensely important asset that allows managers to launch new products and start projects with a data-driven mindset.

They can be a tax deduction

Depreciation reduces the amount you might pay in taxes. Depreciation expenses lower the earnings in a given period, which then reduces the taxes. Calculating and monitoring fixed costs associated with the depreciation of machines, buildings and other equipment can help take advantage of tax liability savings. The remaining funds can then benefit the company through investments like business expansion and new valuable equipment for the company.

Related: Explanation, Benefits and Example of Variable Cost

Application of fixed cost calculation

There are a few calculations that help businesses assess the performance and feasibility of their companies. Fixed cost is an integral part of various formulas that can help you understand your position and reevaluate business decisions. Here are some calculations that involve fixed cost:

Break-even analysis

Break-even analysis is used to calculate the production volume for a product or service that covers all the expenses. It shows how many sales can compensate both fixed and variable costs. Here is the formula for break-even volume:

Break-even volume = fixed costs / (price – variable costs)

This formula determines the point when your investment pays off, meaning you have neither lost money nor made a profit. Break-even analysis helps businesses evaluate the feasibility of business expansion. It's also helpful to entrepreneurs considering purchasing a small venture as they can go into this endeavour with more information about future profits. The formula gives you the volume and the price required to make the business profitable. Based on these numbers, entrepreneurs can decide whether the business idea is credible. You can only manipulate the break-even point by lowering the fixed costs or increasing the price.

Economies of scale

Economies of scale are cost advantages that derive from producing more goods on a larger scale and taking advantage of lower costs per unit. Economies of scale can be internal or external, meaning that the company can either benefit from a mass production machine within the business or from the improved infrastructure across the industry. Calculating economies of scale can give an understanding of how far you need to expand the business to receive the cost-saving effect.

To determine whether economies of scale occurs at a company, you can calculate cost elasticity, which is the responsiveness of total costs to changes in the output. Here is the formula for cost elasticity:

Cost elasticity = per cent change in total costs / per cent change in output

If the cost elasticity is less than one means that the change in costs is lower than the change in output and indicates that economies of scale exists.

Operating leverage

Operating leverage is a proportion of fixed costs in relation to variable expenses. The higher the number, the larger the profit from each additional sale. Lower operating leverage indicates that the company's variable costs exceed fixed costs. As a result, more sales lead to only small increases in profit. The formula for operating leverage is:

Operating leverage = [Q x (P - V)] ÷ [Q x (P - V) - F]

Where:

Q = number of units

P = price per unit

V = variable cost per unit

F = fixed costs

Cost of Goods Manufactured (COGM)

COGM is the total amount of costs that go into turning raw materials into finished ready-for-sale goods. The costs include direct labour expenses, costs of materials, overhead costs with subtraction of ending inventory. This calculation allows managers to assess the overall production costs and possibly make some changes to boost profitability. The formula for COGM is:

COGM = beginning work-in-process inventory + total manufacturing cost – ending work-in-process inventory

Property, Plant and Equipment (PPE)

The ability to calculate and control fixed costs can also help managers decide whether it's a good idea to invest in PPE. Having multiple employees can lead to high direct labour costs, which often affects operating leverage and overall productivity negatively. You can invest in a few machines that reduce the need for manual labour, decrease variable costs and increase stable and predictable fixed costs. PPE calculation looks like this:

The total value of all buildings, land, equipment, property, furniture and other physical capital that a business has acquired for business purposes. Here is the formula for PPE turnover:

PPE turnover = revenue / PPE

If a company has a high PPE turnover, it means that it's using available assets efficiently.

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