Fixed Costs
Cost that is not dependent on changes in the production of goods and services.
What Is a Fixed Cost?
Fixed costs refer to a cost that is not dependent on changes in the production of goods and services. It is also called indirect or overhead costs.
Variable costs constitute the total cost. Some cost accounting methods, like activity-based cost, allocate these costs to businesses for a purpose.
Overhead costs are an expense a company must pay even if no production is happening; it is not affected by changes in the goods and services produced or sold.
These costs are not directly incurred in the production process, so they are called indirect costs. Depreciation is considered a very common fixed cost that can be recorded as an indirect expense in the business's financial statements.
It can be calculated using the following formula:
Fixed Costs = Total Costs - Variable Costs
Where total and variable cost is given.
It plays an integral role in the break-even analysis and cost-structure analysis. It can be calculated using the break-even analysis formula as follows:
Break Even Quantity = Fixed Costs/ (Sales Price Per Unit - Variable Cost Per Unit)
Some examples of overhead costs are:
- Rent and lease costs
- Insurance payments
- Tax on property
- Loan repayments
- Salaries of full-time workers or management
- Utilities
Key Takeaways
- Fixed costs, also known as indirect or overhead costs, remain constant regardless of the level of production or sales. They are essential expenses that a business must incur even if no goods or services are being produced.
- Common examples of fixed costs include rent or lease payments, insurance premiums, property taxes, loan repayments, and salaries of full-time employees or management. These costs are considered mandatory and contribute to the overall stability of the business.
- Higher fixed costs can lead to lower profits, especially during periods of declining sales or revenue. Managing fixed costs effectively is crucial for maintaining profitability in the long run.
- Understanding fixed costs is vital for break-even analysis and informed decision-making in business operations.
Understanding fixed costs (FC)
These costs are considered less controllable than variable costs, which change with the changes in the production level of goods and services. Hence, they remain constant at any point of production in the firm.
Average fixed cost (AFC) is the FC per unit measured by the total fixed cost (TFC) divided by the output level. The formula is as follows:
Average Fixed Cost (AFC) = Total Fixed Cost/ Total Output
These costs are affected by several factors:
- Changes in business organization
- Changes in technology applied
- Sale of manufacturing equipment
- Decisions to buy or sell the company assets
- Field of services
- Advertising services
FCs are reviewed as an independent variable allocated on the accrual basis of accounting in the business.
Fixed are also known as overhead costs, fixed costs are typically indirect expenses that are not directly tied to the production of goods or services.
All sunk costs are considered fixed costs, but not all are considered sunk costs, as they cannot be recovered. These costs are also considered irrelevant in contrast to variable costs, which are considered relevant costs.
If these costs rise in the long run, this situation could lead the company to exit the market and close the business, as these costs are mandatory.
Higher FC can negatively impact profits. Thus these costs can help the business make decisions regarding products and their characteristics.
The company's operating leverage is also affected by fixed and variable costs. The proportion of fixed costs to variable costs needs to be measured. Hence, higher costs facilitate a rise in operating leverage.
Also, companies with higher operating leverage produce higher profits on additional units produced. The formula can calculate this:
Operating Leverage = [Number of units * (Price per Unit - Variable Cost per Unit)]/ [Number of units * (Price per unit - Variable Cost per Unit) - Fixed Costs]
Characteristics of Fixed Cost
Some of the characteristics of fixed costs include:
1. Invariance to Production Levels: Fixed costs remain constant regardless of the volume of goods or services produced. Whether production is high or low, fixed costs do not fluctuate.
2. Stability and Predictability: Fixed costs offer stability to a company's financial planning as they remain unchanged over a certain period, facilitating more accurate budgeting and forecasting.
3. High Initial Investment: Many fixed costs involve significant initial investments, such as purchasing or leasing property, equipment, or infrastructure, which are essential for business operations.
Fixed costs are allocated to products or services through absorption costing methods, enabling companies to determine the total cost of production and set prices accordingly.
4. Long-term Commitments: Fixed costs often entail long-term commitments, such as multi-year lease agreements or loan repayments, which can impact a company's financial flexibility and risk management strategies.
5. Absorption by Production: While fixed costs are not directly influenced by production levels, they are absorbed by the production process, contributing to the cost of each unit manufactured when spread over a larger production volume.
6. Importance in Cost Control: Effective management of fixed costs is crucial for maintaining profitability, as reducing fixed costs can directly improve a company's bottom line without necessarily increasing sales revenue.
How to calculate total fixed costs
There are several examples of determining these costs and calculating the same using various formulas. Following are some of the examples which help more in understanding these costs.
Example 1:
Following are some given values,
- Total cost = $250,000
- Variable cost per unit = $10
- Number of units produced = 10,000
- Calculate the fixed costs for the company.
FC = Total cost - (Variable cost per unit Number of units produced)
= $250,000 - ($10 X 10,000)
= $250,000 - $100,000
= $150,000
Example 2:
Calculate average fixed costs (AFC) by following details:
- Total cost for producing shirts = $150,000
- Variable costs = $50,000
- Number of shirts produced/ total output = 1000
Answer:
FC = Total costs - Variable costs
= $150,000 - $50,000
= $100,000
AFC = Total fixed costs / Total output
= $100,000 / 1,000
= $100
In cost accounting, fixed costs are often allocated across production units to determine the overhead cost per unit.
Example 3:
Calculation of fixed costs using break-even analysis and the following given details:
- Sales per unit = $20
- Variable cost per unit = $10
- TFC = $280,000
- Total units = 1500
Answer:
Break Even Quantity = (Total Fixed Costs)/ (Sales per Unit * Units Produced - Variable Cost per Unit * Units Produced)
= $280,000 / ($20 * 1500 - $10 * 1500) = $280,000 / ($30,000 - $15,000)
= $280,000 / $15,000 = 18.66
Example 4:
State which one of the following is considered fixed costs:
- Loan repayments
- Direct labor
- Insurance payments
- Direct materials
- Property tax
- Rent costs
- Mortgage costs
Answer:
The following are considered fixed costs:
a) Loan repayments
c) Insurance payments
e) Property tax
f) Rent costs
g) Mortgage costs
Advantages Of Fixed Cost
Fixed costs play a fundamental role in business operations, providing stability and essential support for day-to-day activities. Some of the advantages of fixed cost are as follows:
1. Stability: Fixed costs provide a stable foundation for businesses by remaining constant regardless of fluctuations in production or sales volumes.
2. Predictability: Since fixed costs are known and consistent, they facilitate accurate budgeting and financial planning, allowing businesses to forecast expenses with confidence.
While fixed costs ensure a minimum level of operation, they can also impact profitability, particularly in periods of low sales or unexpected downturns.
3. Ease of Accounting: Fixed costs are relatively straightforward to account for, making financial management and reporting more manageable for businesses, auditors, and stakeholders.
4. Enhanced Business Operations: By covering essential overhead expenses like rent, utilities, and salaries, fixed costs ensure the continuity of business operations, contributing to long-term sustainability.
5. Cost Efficiency: In some cases, fixed costs can offer economies of scale, meaning that the cost per unit decreases as production levels increase, resulting in potentially higher profitability.
Disadvantages Of Fixed Cost
Some of the drawbacks of fixed cost include:
1. Impact on Profitability: High fixed costs can lead to reduced profitability during periods of low sales or revenue, as these costs must still be covered regardless of business activity levels.
2. Rigidity: Fixed costs are inflexible and cannot be easily adjusted in the short term, making it challenging for businesses to adapt to changes in market conditions or unexpected financial challenges.
Fixed costs remain constant irrespective of the level of production activity or output. This characteristic distinguishes them from variable costs, which fluctuate based on production volumes.
3. Risk Exposure: Since fixed costs are incurred regardless of business performance, they can pose a financial risk if revenues fall short of covering these expenses, potentially leading to financial strain or even business failure.
4. Cost Inefficiency: Inefficient allocation or utilization of fixed resources can result in underutilized capacity, leading to higher unit costs and reduced competitiveness in the market.
5. Reduced Agility: High fixed costs can hinder a business's ability to respond quickly to changes in customer preferences, technological advancements, or competitive pressures, limiting its agility and ability to innovate.
Effects Of Fixed Cost On Company's Profitability
Understanding the effects of fixed costs on profitability is essential for companies to manage their finances effectively, maintain healthy profit margins, and achieve long-term sustainability in competitive markets. Below are some of the effects:
1. Impact on Break-Even Point
Fixed costs contribute to the break-even point, the level of sales at which total revenue equals total costs.
Higher fixed costs increase the break-even point, requiring the company to achieve a higher sales volume to cover these expenses and start generating profits.
2. Profit Margin Sensitivity
Since fixed costs remain constant regardless of sales volume, changes in revenue have a significant impact on profit margins. During periods of low sales, fixed costs represent a larger proportion of total costs, leading to lower profit margins.
3. Operating Leverage
Fixed costs influence a company's operating leverage, the ratio of fixed costs to variable costs. Higher fixed costs result in higher operating leverage, meaning that small changes in sales can have a magnified effect on profits.
Fixed costs contribute to a company's operating leverage, where a higher proportion of fixed costs relative to variable costs can amplify profits during periods of increased sales but can also magnify losses during downturns.
4. Risk of Losses
In situations where sales fall below the break-even point, fixed costs can contribute to losses for the company. Failure to cover fixed costs can lead to financial strain and potentially jeopardize the company's long-term viability.
5. Investment Decisions
Fixed costs impact investment decisions by affecting the company's ability to allocate resources effectively. High fixed costs may deter companies from investing in new projects or expansions.
6. Profitability Analysis
Fixed costs play a crucial role in profitability analysis, helping companies assess the feasibility of various business initiatives and make strategic decisions to optimize cost structures and maximize profits.
Conclusion
Fixed costs serve as a cornerstone of financial stability for businesses, offering predictability and essential support for ongoing operations.
While they provide benefits such as ease of accounting and stability, businesses must also navigate their potential drawbacks, including inflexibility and risk exposure during periods of low revenue.
Understanding the role of fixed costs and effectively managing them is crucial for businesses to maintain financial health and adaptability in an ever-changing market landscape.
By recognizing both the advantages and challenges associated with fixed costs, businesses can make informed decisions to optimize their cost structures and enhance overall profitability.
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