Fixed costs are costs that do not change in relation to levels of production, unlike variable costs, which do. Fixed costs remain relatively constant on a month-to-month basis. They do change slightly over the long term, but compared to variable costs they remain pretty much the same – more significantly, they are not affected by business activity.
Fixed costs are expenses that a business has to pay, regardless of business activity. For example, rent is a fixed cost – it does not go up when sales or production increase.
Total costs are made up of two components: 1. Fixed costs. 2. Variable costs.
As production increases fixed costs remain the same, but variable costs rise.
In management accounting, as mentioned above, fixed costs are defined as business expenses that do not fluctuate according to levels of activity within a relevant period.
In marketing, it is vital to know how costs divide between fixed and variable. This distinction is important in forecasting the earnings generated by unit-sales changes, and thus the financial impact of suggested marketing campaigns.
In financial analysis, the concept is used to find a business’ breakeven point, as well as determining product pricing.
Fixed costs have to be paid for on a regular basis, and so are seen as periodic costs. The amount charged to expense generally changes very little from period to period.
Fixed costs (Left) include insurance premiums, office rent and utilities. Examples of variable costs (Right) are labor and materials used for production.
Fixed cost breakdown
Imagine a company called John Doe Inc. – which manufactures door-handles – has a lease on a building which costs $15,000 per month If during one month the company has no production, it still has to pay the $15,000 for that month in full.
Businesses can achieve economies of scale when they produce enough goods to spread fixed costs. For example, John Doe’s $180,000 annual lease spread over 1.8 million door-handles produced in one year means that each unit carries with it $0.10 or ten cents in fixed cost. If production jumps to 3.6 million units, the fixed cost per unit goes down to five cents per unit. This example just looked at the lease cost – fixed costs include utilities, some office supplies and other items.
As production increases fixed cost per unit goes down, while the variable cost per unit remains about the same (it may decline slightly if the company can get discounts from suppliers because it is buying materials in larger quantities).
Businesses with high fixed costs
Companies with a large fixed cost component have to generate considerable amount of sales volume in order to have sufficient contribution margin to offset the fixed cost. However, as soon as that sales level has been reach, this type of business typically has relatively low variable cost per unit, so it can generate exceptional profits above the breakeven level.
Let’s look at an oil refinery as an example. Fixed costs are huge in relation to its refining capacity. If the cost of a barrel of oil falls below a certain price, the refinery runs at a loss. However, when prices rise beyond a certain level it can be incredibly profitable.
Generally, the higher the fixed cost, the easier it is to increase production rapidly – a bit like all you have to do is turn the tap onto full.
On the other hand, if a business has low fixed costs, its breakeven point is much lower and therefore easier to reach, but it has a high variable cost per unit. Low fixed cost companies can earn a profit with much lower sales volume levels than high fixed cost businesses, but their profits are not so huge when sales increase.
Consulting businesses, for example, have extremely low fixed costs – most of its costs are variable.
Economist say that ultimately, all costs eventually are variable. Take for example management salaries, which typically do not vary according to the number of units produced. However, if the company falls on very hard times and layoffs occur, those expenses will change significantly.
The Financial Times ft.com/lexicon defines a fixed cost as follows:
“Cost that does not change even if output or sales volume changes. The opposite of variable cost.”
Video – What are fixed costs?
This video, by the Inverstors Trading Academy, explains in simple terms what fixed costs are.