Fixed Cost Definition
A fixed cost is a cost which does not vary with the level of production or selling activity. Fixed costs are a function of the passage of time and are sometimes referred to as periodic costs for this reason.
Fixed Cost Examples
Suppose the rent on a production facility is 2,000 per month. The amount of rent paid in the month does not vary with the level of production activity. The factory might produce 1,000 or 5,000 units but the rent will remain fixed at 2000 per month.
The total amount of rent paid is a function of time, it is periodic. For one month the rent will be 2,000, for 2 months the total rent will be 2,000 x 2 = 4,000, and so on.
It might well be that after 5 years the landlord will increase the rent to say 3,000 per month. The rent is still a fixed cost, it has not varied in the relation to the level of production activity within the business. Such a cost is often called a step fixed cost, as it changes in steps over a period of time.
If salaries are not related to the level of production or selling activity, then they are fixed costs. For example management salaries will not change with the level of factory output.
Depreciation can be a fixed cost. For example a machine is purchased for 25,000 and has a 5 year useful life. On a straight line basis the depreciation is 25,000 / 5 = 5,000 per year. The depreciation is fixed it will not vary with the level of production output.
The nature of it being fixed has been determined by the method of depreciation. Had the business decided to write the machine off based on usage (say production hours), then it would have varied with the level of production and would not be classified as fixed costs.
Advertising that does not vary with the level of sales activity is a fixed cost.
Insurance is normally a fixed cost. For example, the insurance on a building is a fixed amount per year and does not vary with the level of activity of a business.
Labor is not normally a fixed cost as it will vary with the level of production. There are of course examples of labor which do not vary with the level of business activity and these would be classified as fixed.
Importance of Fixed Cost Identification
It is important for a business to identify which of its costs are fixed for a number of reasons.
Break even point
The level of fixed costs will directly affect the break even point of the business.
The break even sales for a business is given by the formula, Break Even Point = Fixed Costs / Gross Margin %. For a given gross margin %, the higher the fixed costs, the higher the sales needed to break even. If a business is running at a loss and sales are falling, one method of correcting the situation is to bring down the break even point by reducing the fixed costs.
Fixed Costs per Unit
The fixed cost per unit will directly affect the price which a business is able to sell its product and make a profit. The fixed cost per unit needs to be a low as possible. Fixed costs remain the same irrespective of how many units are produced. Because of this the fixed cost per unit will fall as the number of units produced increases, and an economy of scale will result.
For example, if a business has fixed costs of 2,000 and produces 1,000 units, then the fixed costs per unit is 2,000 / 1,000 = 2 per unit. However, if production increases to 5,000 units the fixed costs are still 2,000, but the fixed cost per unit will have fallen to 2,000 / 5,000 = 0.40 per unit.
Risk and Fixed Cost
A business with higher fixed costs is normally considered to be more risky than one with lower. The reason for this is that the business is more vulnerable to a fall in sales, as the costs cannot be contracted to match.
Fixed Cost Barrier to Entry
High fixed costs can discourage competitors from entering the market.
Fixed Costs vs Variable Costs
Fixed costs are incurred whether or not a business has any production or selling activity, in contrast variable costs do vary with the level of production or selling activity within the business.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.