What Is a Fixed Cost?
The term fixed cost refers to a 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 specific business activities. This means fixed costs are generally indirect, in that they don't apply to a company's production of any goods or services. Companies can generally have two types of costs—fixed or variable costs—which together result in their total costs. Shutdown points tend to be applied to reduce fixed costs.
- Fixed costs refer to expenses that a company must pay, independent of any specific business activities.
- These costs are set over a specified period of time 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.
- Companies have interest payments as fixed costs which are a factor for net income.
- Cost structure management is an important part of business analysis that looks at the effects of fixed and variable costs on a business overall.
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 analyze 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 costs can be used to calculate several key metrics, including a company's breakeven point and operating leverage.
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 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 x (P - V)] ÷ [Q x (P - V) - F]
- 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.
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 and therefore change depending on business output. These costs can increase or decrease with respect to production levels or sales. Variable costs are generally associated with things like raw materials and shipping costs.
Companies have some flexibility when it comes to breaking down costs on their financial statements, and fixed costs can be allocated throughout their income statement. The proportion of fixed versus variable costs that a company incurs and its allocations can depend on its industry.
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 they are working with.
Economies of scale can also be a factor for companies that can produce large quantities of goods. Fixed costs can be a contributor to better economies of scale because fixed costs 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.
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)
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 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 but are instead related to new contractual agreements or schedules.
What Are Some Examples of Fixed Costs?
Common examples of fixed costs include rental lease or mortgage payments, salaries, insurance payments, property taxes, interest expenses, depreciation, and some utilities.
Are All Fixed Costs Considered Sunk Costs?
All sunk costs are fixed 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.
It's easy to imagine a scenario where fixed costs are not sunk. For example, equipment might be resold or returned at the purchase price.
Individuals and businesses both incur sunk costs. For example, someone might drive to the store to buy a television, only to decide upon arrival to not make the purchase.
The gasoline used in the drive is, however, a sunk cost—the customer cannot demand that the gas station or the electronics store compensate them for the mileage.
How Are Fixed Costs Treated in Accounting?
Fixed costs are associated with the basic operating and overhead costs of a business. Fixed costs are considered indirect costs of production, which means they are not costs incurred directly by the production process, such as parts needed for assembly, but they do factor into total production costs. As a result, they 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 as the cost of goods sold, 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 down significantly.