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Fixed Cost: What It Is, How It Works

What Is a Fixed Cost?

A fixed cost is a business expense that often remains constant regardless of changes in the volume of goods or services produced or sold by the business.

Fixed costs are commonly associated with recurring expenses not directly tied to production, such as rent, interest payments, insurance, depreciation, and property taxes.

Since fixed costs are unrelated to a company’s production activities, they are generally considered indirect costs. Fixed costs, along with variable costs, comprise the total cost of running a business.

Key points:

  • Fixed costs are expenses that are not influenced by a company’s operational activities.
  • They are set for a specific period and do not fluctuate with changes in production levels.
  • Fixed costs can be direct or indirect and may impact profitability at different points on the income statement.
  • Unlike fixed costs, variable costs are directly associated with production and fluctuate based on output levels.
  • Fixed costs are crucial for calculating key financial metrics, including breakeven analysis and operating leverage.

How Fixed Costs Work

Fixed costs, also known as fixed expenses, remain constant regardless of production levels. They are often determined by contractual agreements or predefined schedules and represent the essential baseline expenses required to operate a business. Once established, fixed costs remain unchanged throughout the duration of the agreement or schedule.

Fixed Costs on Financial Statements

Fixed costs are allocated in the indirect expense section of the income statement, contributing to the calculation of operating profit. Depreciation is a common fixed expense recorded as an indirect expense. Companies create a depreciation expense schedule for asset investments whose values depreciate over time.

For example, a company might purchase machinery for a manufacturing assembly line, which is expensed over time through depreciation. Another primary fixed and indirect cost is management salaries. Fixed costs listed on the income statement are likewise reflected on both the balance sheet and cash flow statement. On the balance sheet, fixed costs can be classified as either short-term or long-term liabilities. Any cash used to pay for fixed cost expenses is reflected on the cash flow statement.

In general, reducing fixed costs can benefit a company’s bottom line by lowering expenses and increasing profit.

Factors Associated With Fixed Costs

Companies analyse both fixed and variable expenses when assessing costs per unit. Consequently, the cost of goods sold (COGS) may encompass both types of expenses. All costs directly associated with producing a good are aggregated and then subtracted from revenue to determine gross profit. Cost accounting practices differ among companies based on the specific costs they incur.

Economies of scale can significantly impact companies producing large quantities of goods. Fixed costs contribute to better economies of scale because they decrease per unit when spread over a larger number of units. In other words, per-unit fixed costs diminish as production volume increases.

Fixed costs directly associated with production can vary by company but often include expenses like direct labour and rent.

Note: Companies have some flexibility in how they break down costs on their financial statements. Fixed costs can be distributed throughout the income statement. The proportion of fixed to variable costs, as well as their allocation, often depends on the industry.

Examples of Fixed Costs

Fixed costs encompass a variety of expenses, such as rental and lease payments, certain salaries, insurance, property taxes, interest expenses, depreciation, and some utilities.

For example, someone starting a new business would often incur fixed expenses for rent and management salaries.

All types of companies have fixed-cost agreements that they regularly monitor. Although these fixed costs may change over time, the changes are not related to production levels but rather to new contractual agreements or schedules.

Fixed Cost vs. Variable Cost

Fixed expenses are often negotiated for a specified period and do not decrease on a per-unit basis when associated with the direct cost section of the income statement. They fluctuate within the breakdown of the cost of goods sold.

Unlike fixed costs, variable costs are directly associated with production and change according to 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 is important for analysts to compare companies within the same industry.

Examples of variable costs include labour, utilities, raw materials, shipping costs, and commissions.

Another type of expense is a hybrid between fixed and variable costs known as semi-variable costs. These expenses have both fixed and variable components, remaining fixed up to a certain level of production. Once this threshold is surpassed, the costs become variable. Common examples of semi-variable costs include expenses for repairs and electricity.

Calculating Breakeven and Operating Leverage with Fixed Expenses

Fixed expenses play a crucial role in determining various metrics such as a company’s breakeven point and operating leverage.

Breakeven Analysis

A breakeven analysis involves utilising both fixed and variable costs to determine the production level at which revenue equals costs, a crucial aspect of cost structure analysis.

The breakeven production quantity for a company is calculated by dividing Fixed Costs by the difference between Sales Price per Unit (SPPU) and Variable Cost per Unit (VCPU).

Breakeven Point = Fixed Costs ÷ (SPPU−VCPU)

where:

SPPU = Sales price per unit

VCPU = Variable cost per unit

This analysis informs decisions concerning fixed and variable costs and also impacts the pricing strategy adopted by the company for its products.

Operating Leverage

Operating leverage serves as a crucial metric in managing cost structures within companies. It indicates the ability to generate increased profits per additional unit produced, particularly evident with higher operating leverage.

The ratio of fixed to variable costs significantly impacts a company’s operating leverage. Greater fixed costs contribute to heightened operating leverage. This metric can be determined through the subsequent formula:

Operating Leverage = (Q×(P−V)) ÷ ((Q×(P−V))−F)

where:

Q = Number of units

P = Price per unit

V = Variable cost per unit

F = Fixed costs

Cost Structure Management and Ratios

Apart from financial statement reporting, most companies meticulously track their cost structures using independent cost structure statements and dashboards.

Independent cost structure analysis enables a comprehensive understanding of fixed and variable costs and their impact on various segments of the business, as well as the overall business performance. Many companies employ dedicated cost analysts to continuously monitor and analyse fixed and variable costs.

On the other hand, the fixed charge coverage ratio serves as a solvency metric, assessing a company’s capacity to meet its fixed-charge obligations. It is computed using the following equation:

(EBIT + Fixed Charges Before Tax) ÷ (Fixed Charges Before Tax + Interest)

Note: The fixed cost ratio, a straightforward calculation, divides fixed costs by net sales. This ratio serves to ascertain the portion of fixed costs in production.

Conclusion

In business, expenses are often classified into two main categories: fixed costs and variable costs. Fixed costs remain constant regardless of production levels, such as rent. Conversely, variable costs fluctuate based on production levels, like shipping fees.

DISCLAIMER: This article is for informational purposes only and is not meant to supersede official business advice.

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