Fixed Cost
What Is a Fixed Cost?
A fixed cost is a cost that does not change with an increase or decrease in the
amount 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.
In general, companies can have two types of costs, fixed costs or variable costs,
which together result in their total costs. Shutdown points tend to be applied to
reduce fixed costs.
KEY TAKEAWAYS
Cost structure management is an important part of business analysis that
looks at the effects of fixed and variable costs on a business overall.
Fixed costs are set over a specified period of time and do not change with
production levels.
Fixed costs can be direct or indirect expenses and therefore may influence
profitability at different points along the income statement.
Understanding Fixed Costs
Companies have a wide range of different costs associated with their business.
These costs are broken out by indirect, direct, and capital costs on the income
statement and notated as either short-term or long-term liabilities on the balance
sheet. Together both fixed costs and variable costs make up the total cost
structure of a company. Cost analysts are responsible for analyzing both fixed
and variable costs through various types of cost structure analysis. In general,
costs are a key factor influencing total profitability.
Companies have some flexibility in breaking down costs on their financial
statements. As such fixed costs can be allocated throughout the income
statement. The proportion of variable vs. fixed costs a company incurs and their
allocations can depend on the industry they are in. Variable costs are costs
directly associated with production and therefore change depending on business
output. Fixed costs are usually negotiated for a specified time period and do not
change with production levels. Fixed costs, however, can 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.
Fixed costs are usually established by contract agreements or schedules. These
are base costs involved in operating a business comprehensively. Once
established, fixed costs do not change over the life of an agreement or cost
schedule. A company starting a new business would likely begin with fixed costs
for rent and management salaries. All types of businesses 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 rather new contractual
agreements or schedules. Examples of fixed costs include rental lease
payments, salaries, insurance, property taxes, interest expenses, depreciation,
and potentially some utilities.
Financial Statement Analysis
Companies can associate both fixed and variable costs when analyzing costs per
unit. As such, cost of goods sold can include both variable and fixed costs.
Comprehensively, all costs directly associated with the production of a good are
summed collectively and subtracted from revenue to arrive at gross profit.
Variable and fixed cost accounting will vary 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.
Fixed costs are also 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.
Companies will also have interest payments as fixed costs which are a factor for
net income. Fixed interest expenses are deducted from operating profit to arrive
at net profit.
Any fixed costs on the income statement are also accounted for on the balance
sheet and cash flow statement. Fixed costs on the balance sheet may be either
short-term 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.
Cost Structure Management
In addition to financial statement reporting, most companies will closely follow
their cost structures through independent cost structure statements and
dashboards. Independent cost structure analysis helps a company fully
understand its variable vs. fixed 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.
Ratios
Fixed cost ratio: 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.
Fixed charge coverage ratio: The fixed charge coverage ratio 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
Other Considerations
Breakeven analysis: Breakeven analysis involves using both fixed and variable
costs to identify a production level in which revenue will equal costs. This can be
an important part of cost structure analysis. A company’s breakeven production
quantity is calculated by:
Breakeven quantity = 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. Breakeven analysis also influences the price at which a company
chooses to sell its products.
Operating leverage: Operating leverage is another cost structure metric used in
cost structure management. The proportion of fixed to variable costs will
influence a company’s operating leverage. Higher fixed costs help operating
leverage to increase. With a higher operating leverage, companies can produce
more profit per additional unit produced.
Operating leverage = [Q(P-V)] / [Q(P-V)-F]
Where:
Q = number of units
P = price per unit
V = variable cost per unit
F = fixed costs
Frequently Asked Questions
What are some examples of fixed costs?
Common examples of fixed costs include rental lease or mortgage payments,
salaries, insurance, property taxes, interest expenses, depreciation, and
potentially some utilities.
Are all fixed costs considered sunk costs?
In financial accounting, all sunk costs are fixed costs. However, 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 re-sold 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. They are not
costs incurred directly by the production process, such as parts needed for
assembly, but they nonetheless factor into total production costs. As a result,
they are depreciated over time, and not 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 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 down significantly.
