Fixed Cost: What It Is and How It’s Used in Business

What Is a Fixed Cost?

Fixed cost refers to the cost of 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, and insurance.

Since fixed costs are not related to a company’s production of any 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—the other being variable costs—that together result in their total costs.

Understanding Fixed Costs

The costs associated with doing business can be broken out by indirect, direct, and capital costs on the income statement and notated as either short- or long-term liabilities on the balance sheet. Both fixed and variable costs make up the total cost structure of a company. Cost analysts evaluate both fixed and variable costs through various types of cost structure analysis. Costs are generally a key factor influencing total profitability.

Fixed costs are those that don’t change over the course of time. 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 one common fixed cost 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, 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.

Fixed vs. Variable Costs

As noted above, fixed costs are any expenses that a company incurs that never change during the course of running a business. Fixed costs 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.

Variable costs, on the other hand, 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. Variable costs are generally associated with items like raw materials and shipping costs.

Factors Associated with Fixed Costs

Companies can associate fixed (and variable) costs when analyzing costs per unit. As such, the cost of goods sold (COGS) can include both types of costs. All costs directly associated with the production of 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 that can produce 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.

Special Considerations

Fixed costs 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:

Breakeven Point = Fixed Costs ÷ (Sales Price per Unit – Variable Cost per Unit)

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:

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

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 the fixed and variable costs of a business.

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:

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

Examples of Fixed Costs

Fixed costs include any number of expenses, including rental lease payments, salaries, insurance, property taxes, interest expenses, depreciation, and potentially some utilities.

For instance, someone who starts a new business would likely begin with fixed costs 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.

The Bottom Line

Fixed costs are one of two types of business expenses. The other is variable costs. Fixed costs are expenses that 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.