What Is a Fixed Cost?

What Is a Fixed Cost?

Let me explain what a fixed cost is: it's a business expense that normally doesn’t change with an increase or decrease in the number of goods and services you produce or sell. These are typically recurring expenses not directly tied to production, like rent, interest payments, insurance, depreciation, and property tax. Remember, fixed costs are the opposite of variable costs, which fluctuate as you manufacture more or fewer products.

Understanding Fixed Costs

You should know that fixed costs don’t change with production levels. I refer to them as fixed expenses, usually established by contract agreements or schedules. These are the base costs for operating your business. Once set, they do not change over the life of an agreement or cost schedule.

Fixed Costs on Financial Statements

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

For example, if you buy machinery for a manufacturing assembly line, it's expensed over time using depreciation. Another primary fixed and 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. Any cash used to pay fixed cost expenses is shown on the cash flow statement.

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

Factors Associated With Fixed Costs

Companies examine fixed and variable expenses when analyzing costs per unit. As such, the cost of goods sold (COGS) can include both types of costs. All costs directly associated with producing a good are summed and subtracted from revenue to arrive at gross profit. Cost accounting varies for each company depending on the costs they work with.

Economies of scale can also be a factor for companies producing large quantities of goods. Fixed costs can contribute to better economies of scale because they decrease per unit when larger quantities are produced. That is, per-unit fixed costs drop when spread out over more units.

Fixed costs that may be directly associated with production will vary by company but can include costs like direct labor and rent.

Companies have some flexibility when breaking down costs on their financial statements, and fixed costs can be allocated throughout their income statement. The proportion of fixed to variable costs and how they're allocated can depend on the industry.

Examples of Fixed Costs

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

For instance, if you start a new business, you would likely begin with fixed expenses 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.

Fixed Cost vs. Variable Cost

Fixed expenses are usually negotiated for a specified period but can't decrease on a per-unit basis when associated with the direct cost section of the income statement, fluctuating in the breakdown of costs of goods sold.

Unlike fixed costs, variable costs are directly associated with production. Therefore, they change depending on 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's important to make comparisons between companies in the same industry.

Examples of variable costs include the cost of labor, utilities, raw materials, shipping costs, and commissions.

Fast Fact on Semi-Variable Costs

Another type of expense is a hybrid between fixed and variable costs. Semi-variable costs are composed of fixed and variable components, which means they are fixed for a certain production level. After this threshold, the costs become variable. Some common examples include repairs and electricity.

Special Considerations

Fixed expenses 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 at which revenue equals costs. This can be an important part of cost structure analysis. You calculate a company’s breakeven production quantity as: Breakeven Point = Fixed Costs / (SPPU - VCPU), where SPPU is sales price per unit and VCPU is variable cost per unit.

A company’s breakeven analysis can be important for decisions about fixed and variable costs. It also influences the price at which a company chooses to sell its products.

Operating leverage is a cost structure metric used in cost structure management. Companies can generate more profit per additional unit produced with higher operating leverage. The proportion of fixed to variable costs influences operating leverage. Higher fixed costs help increase operating leverage. You calculate it as: Operating Leverage = [Q × (P - V)] / [(Q × (P - V)) - F], where Q is number of units, P is price per unit, V is variable cost per unit, and F is fixed costs.

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 you fully understand 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 to monitoring and analyzing these costs.

The fixed charge coverage ratio is a solvency metric that helps analyze a company's ability to pay its fixed-charge obligations. It's calculated as: (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. It's used to determine the proportion of fixed costs involved in production.

Are All Fixed Costs Considered Sunk Costs?

All sunk costs are fixed costs in financial accounting, but not all fixed costs are considered sunk. The defining characteristic of sunk costs is that they cannot be recovered.

How Are Fixed Costs Treated in Accounting?

Fixed costs are associated with a business's basic operating and overhead costs. They are considered indirect costs of production, meaning they are not costs incurred directly due to the production process, such as costs for parts needed for assembly. However, they do factor into total production costs. As a result, fixed costs 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 (COGS), 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 significantly.

The Bottom Line

A fixed cost is one type of business expense. The other two types are variable and semi-variable costs. Fixed costs are expenses that do not change as production levels change. Rent is one example of a fixed cost. Unlike fixed costs, variable costs like shipping change based on a company's production levels.