What is a Fixed Cost
A fixed cost is an expense or cost that does not change with an increase or decrease in the number of goods or services produced or sold. Fixed costs are expenses that have to be paid by a company, independent of any business activity. It is one of the two components of the total cost of running a business, the other being variable costs.
BREAKING DOWN Fixed Cost
A fixed cost is an operating expense for a business that cannot be avoided regardless of the level of production or sales. Fixed costs are usually used in break-even analysis to determine pricing and the level of production and sales under which a company generates neither profit nor loss. Fixed costs and variable costs together make up the total cost structure of a company, which plays a key role in determining its profitability.
Examples of Fixed Costs
Fixed costs that make up most of a company's total cost structure require it to achieve higher levels of revenues to break even. Fixed costs are incurred regularly, and they tend to show little fluctuation from period to period. Examples of fixed costs include insurance, interest expense, property taxes, utilities expenses and depreciation of assets. Also, if a company pays annual salaries to its employees regardless of the number of hours worked, such salaries are considered fixed costs. A company's lease on a building is another common example of a fixed cost that can absorb significant funds, especially for retail companies that rent their store premises.
Fixed Costs and Economies of Scale
A business must incur variable and fixed costs to produce a given amount of goods. Variable costs per item stay relatively flat, and the total variable costs will change proportionately to the number of product items produced. Fixed costs per item decrease with an increase in production. Thus, a company can achieve economies of scale when it produces enough goods to spread the same amount of fixed costs over a larger number of units produced and sold. For example, a $100,000 lease spread out over 100,000 widgets means that each widget carries with it $1 in fixed costs. If the company produces 200,000 widgets, the fixed cost per unit drops to $0.50.
Companies with large fixed costs and unchanged variable costs in their production process tend to have the greatest amount of operating leverage. This means that after a company achieves the break-even point, all else equal, any further increases in sales will produce higher profits. Conversely, decreases in sales volume can produce disproportionately bigger declines in profits. An example of businesses with high fixed costs are utility companies, which have to make large investments in infrastructure and have subsequently large depreciation expenses with relatively stable variable costs per unit of electricity produced.