Definition of Fixed Cost
The cost that remains constant irrespective of the change in business activities is called as the fixed cost, it does not depend on the sales or the output that the business generates and is relatively easier to be accounted due to its fixed nature.
Explanation
Fixed cost remains the same throughout the year or a financial period (monthly, quarterly, semi- annually or annually) which can be forecasted or predetermined for a particular period. Since the cost remains constant throughout the specified period, it becomes a cake walk to report and audit the fixed costs. Suppose the business comes to a halt due to any reason, the fixed cost would still be payable. The best examples of Fixed Costs are mentioned below:
- Rent
- Installments for loan
- Salary
- Insurance Premiums
- Depreciation
Fixed costs are not limited to the aforementioned but may also include telephone / internet bills and other expenses like electricity bill which is generated on a minimum amount even if there is no consumption.
How to Calculate Fixed Cost?
Fixed cost is calculated by subtracting the product of number of units produced and variable cost per unit from the total cost of production. In simple terms, the fixed cost is derived by subtracting the variable cost from the total cost.
The formula for Fixed Cost is as mentioned below:
Fixed Cost = Total Cost of Production – (Number of Units Produces * Variable Cost Per Unit)
Examples of Fixed Cost
For every business to function, the major fixed costs as mentioned previously are rent, EMIs, salaries and insurance premiums. In the current COVID situation many firms had to hard stop owing to the lockdown norms put forth by governments across the globe. Some business can function only if there is human interference. A simple example would be a cookie manufacturing business. In the lockdown, ChocoChips Inc had to shut down its operations for over 4 weeks which meant no manufacturing for 1 month straight. This stoppage nullified the costs incurred in operating the business like cost of packing and transporting the goods and the bi-weekly maintenance costs although, the manufacturer had to pay the electricity bill, rent and salaries for the employees for the month even when the business was not operational. There was no exception to the installments it made every month for the loan either. Furthermore, the depreciation of the machinery and assets is also accounted for the period irrespective of the COVID situation.
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Applications of Fixed Cost
- When a business is estimating its profits for a specific financial period, fixed costs are an important factor that is considered.
- If an organization wants to enter a new market, the fixed costs in the segment is looked upon as an indicator as to whether it is a wise decision to make an entry into the market with the amount of capital and the risk acceptance.
- An organization that has a high fixed cost is more likely to take the hit on the profit margin when the sales dip, thereby impacting the stocks of the business in the open market.
- Fixed costs can be used to calculate the breakeven point for a project or a business.
Importance of Fixed Cost
- Fixed cost can either be direct or indirect cost and as a result can have an impact on the profitability of the business.
- Since the fixed cost of the business is looked upon as an indicator as to the bare minimum that costs to run the business, if the fixed cost is not monitored and kept below a certain level it can impact the stock value of the business.
- Fixed cost does not change over the specified period and as a result the management can make informed decisions that are best suited according to the market conditions that would boost the sales or reduce the variable cost for operating the business.
Advantages of Fixed Cost
Some of the advantages are:
- Fixed cost as the name suggests is fixed and does not change owing to which the management can keep the fixed cost as an amount that is predetermined and make decisions.
- Fixed cost are based on a specific period and do not change with changes in business activities and outputs.
- Once the fixed costs are identified the costs do not change until the specified period of an agreement or a schedule, thereby brings stability in the business.
- The fixed is relatively easy to record and audit since it does not change for a period of time.
Disadvantages of Fixed Cost
Some of the disadvantages are:
- Fixed costs need to be monitored heavily so that there are no more fixed costs that would result in increasing the cost to operate the business.
- Fixed costs can change in the future due to changes in norms, policies, schedules or agreements.
- The profit of businesses with high fixed cost will be impacted negatively when sales decline.
- Fixed cost has an impact on the profitability of the business and any increase in the fixed costs in the future would result in reduced profits.
Conclusion
In a nutshell, fixed cost is the cost in operating a business irrespective of the reforms in the business activities. The fixed cost is not impacted by any increase or decrease in the outputs produced over a period of time. Since fixed cost does not change it is relatively easier to record and audit fixed costs. For some reason, if the business ceases to operate for a short span, the fixed cost is still payable by the organization unlike operating costs which is bound to be paid to fuel business operations. Businesses have to take conscious efforts to keep fixed costs below a specific limit so that the profitability does not take a hit when sales decline. Additionally, fixed costs can help the management in taking decisions based on the predetermined costs that are in the best interest of the business to thrive in the market conditions.
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