Fixed Cost

What is Fixed Cost?

Fixed costs are the necessary costs that are unchanged even if there is a shift (rise/fall) in a company’s sales or production activity. 

For example, Smith & Co’s income statement shows that the company holds utility bills, property taxes, salaries, wages, and insurance premiums as fixed costs. The total amount accounts for $1,400 million.

It remains the same throughout the year or a financial period (monthly, quarterly, semi-annually, or annually). It can be forecasted or predetermined for a particular period. Since the cost remains constant throughout the specified period, reporting and auditing become a cakewalk. Suppose the business stops for any reason, the indirect costs would still be payable.

Key highlights

• A fixed cost is an obligation a company bears and must pay regardless of the incurred profit or loss.
• It is calculated by subtracting the total cost of production from the product of the number of units produced and the variable cost per unit.
• The factors contributing to it are insurance, wages, rent, maintenance, etc.
• It may impact profitability at varying points on the income statement and might be direct or indirect.
• It is also helpful for investors as it helps them assess the riskiness of an investment in the company.

Examples

There are several factors that can contribute to overhead costs. These costs are unavoidable if you are running a business and must be paid despite the profit and loss. Some of these costs are:

• Rent or mortgage payments- Whether you have a slow or busy month, your rent payment will remain the same.
• Insurance premiums- Insurance helps provide businesses with coverage in an unexpected event such as fire, flood, or theft. This payment remains the same for each financial year.
• Utility bills- Utility bills are a very common example. You pay the same monthly fee for water and electricity whether you use more or less than the month before.
• Equipment leases or purchases- An organization must pay this while purchasing an asset.
• Labor costs- This cost includes both variable and overhead costs. Generally, payment made to full-time employees is a fixed cost.
• Licenses- Many businesses require licenses or permits to operate lawfully and must renew such licenses. For instance, businesses that sell alcohol need to apply for and renew their liquor licenses annually.
• Maintenance- Costs associated with maintenance include cleaning supplies, fixing machinery, and yearly tune-ups for automobiles. Most of the time, this expense is constant and occurs on a predetermined schedule.
• Loans- Many companies take out loans to launch their firms, which they must repay monthly.

Fixed Cost Formula

We calculate fixed cost by subtracting the product of the number of units produced and the variable cost per unit from the total cost of production. Simply put, it is derived by subtracting the variable cost from the total cost.

• Total cost of production: Total cost of production (TCP) is the sum of all the costs incurred in producing a good or service.
• Number of units produced: These are the total number of units an organization produces for a particular accounting period.
• Variable cost per unit: Variable cost per unit is the amount of money a company spends to produce one unit of a product or service. This includes the cost of materials, labor, and other expenses that vary based on production volume.

How to Calculate Fixed Cost? Excel Examples

Example #1

Let’s assume that Gifts & Co. produces 100,000 units of goods per year and the total cost of production is $2,000,000. Also, the variable cost per unit is $10, and the company produces 100,000 units. Calculate the fixed cost.

Given,

Solution:

In this scenario, the fixed cost for the company would be $1,000,000. This means that the company has to clear this cost irrespective of the company’s overall performance.

Example #2

Now let’s take the example of XYZ limited. They have provided the following details-

• Number of units produced= 20000
• Total cost of production per unit= $25
• Variable cost of production= $12 per unit

Calculate the fixed cost for the company.

Given,

Solution:

In this scenario, the fixed cost for the company is $260000. These are some costs that the company is liable to pay despite the rise or fall in profit.

Example #3

ABC Limited is a bag manufacturing company that produced 5000 bags in January 2022. According to the production manager, the total cost of production is $250000. The company also estimated that the variable cost per unit is $40 per unit. Calculate the fixed cost for the company.

Given,

Solution:

The fixed cost for the company is $50000. These costs are likely attributed to employees’ wages, materials required for bag production, insurance charges, etc.

Example #4

We can take another example from Shoe Limited. They have manufactured 100000 units of shoes in the financial year 2021. The company has provided the following details-

• Raw material cost= $20
• Variable labor expenses= $ 10 per unit
• Variable overheads= $15 per unit
• Total cost of production= $5500000

Calculate the fixed cost for the company.

Given,

Now, let’s calculate the total variable cost per unit,

In this scenario, the total variable cost per unit= 20+10+15 = $45 per unit

Solution,

Thus, the fixed cost for the company will be $1000000. The company must pay this regardless of the incurred profit or loss.

Types

Sunk Costs:

• Sunk costs are those that have already been incurred and cannot be recovered.
• An example would be the purchase price of a piece of machinery that is no longer used.

Committed Costs:

• Committed costs are those that have been incurred but can be changed in the future.
• An example would be the monthly rent for factory space. The committed cost will change accordingly if the business decides to move to a new location.

Fixed vs. Variable Costs

Fixed Cost	Variable Cost
They are constant.	Variable costs vary with production output.
It occurs even if the company’s output is zero. For example, a company may have to pay rent for its factory regardless of whether or not it is making any product.	On the other hand, variable costs are those liabilities that incur when the company is actually involved in production.
It includes interest on loans, insurance, rent, property taxes, etc. The company is liable to pay such expenses despite the rise and fall in the business.	It is the cost of raw materials for production. Thus, if there is no production activity, the company need not bear any costs.
It doesn’t fluctuate more and is easier to predict than the variable costs.	Unlike the fixed cost, it is always fluctuating.

Fixed Cost Graph

• The graph above shows the company’s total indirect costs, which are those costs that do not change with production or sales volume, such as rent, property taxes, and interest on the debt.
• The vertical axis represents the costs (millions), while the horizontal axis represents production or sales volume (millions).
• The upper shaded region represents the variable cost, and the line parallel to the y-axis represents the fixed cost.
• The y-intercept is the meeting point on the y axis which represents the fixed costs of the company at the beginning of the production cycle. I.e., when the production is zero.
• A graph is a valuable tool for management because it provides a clear picture of the company’s overall financial health.
• It is also useful for investors because it can help them assess the riskiness of an investment in the company.

Fixed Cost in Break-even Analysis

• In break-even analysis, fixed cost is a key component. It is the total cost of production that does not vary with output.
• Unlike the fixed cost, the variable cost can vary and depends solely on the production output level of services and goods.
• The break-even point is the point at which a company’s revenues exactly cover its expenses. At this point, the company is neither making a profit nor a loss.
• The break-even point is determined by dividing the total costs by the unit selling price minus the variable costs per unit. Formula of break-even point is:

• Let’s say a company has fixed expenses of $100,000 and variable costs of $10 per unit produced. The unit selling price is $20. The break-even point would be: $100,000 / ($20 – $10) = 500 units. At this point, the company will have enough revenue to cover its expenses but not enough to turn a profit. To do that, it would need to produce and sell more units.

Advantages and Disadvantages

Advantages	Disadvantages
It is fixed and does not change, so the management can keep it as a predetermined amount and make decisions.	It needs to be monitored heavily so that no more factors increase the business’s cost.
It is based on a specific period and does not change with changes in business activities and outputs.	It can change in the future due to changes in norms, policies, schedules, or agreements.
Once the overhead costs are identified, the costs do not change until the specified period of an agreement or a schedule, thereby bringing stability to the business.	The profit of businesses with high overhead costs will be impacted negatively when sales decline.
The fixed is relatively easy to record and audit since it does not change for a period of time.	It impacts the business’s profitability, and any increase in indirect costs in the future would result in reduced profits.

Importance

• Fixed costs can be direct or indirect and, as a result, impact the business’s profitability.
• If the fixed cost is not monitored and kept below a certain level, it can impact the stock value of the business.
• It does not change over the specified period. As a result, the management can make informed decisions that are best suited according to the market conditions that would boost sales or reduce the business’s variable cost.
• Also, the overhead cost does not change over the specified period. As a result, the management can make informed decisions that are best suited according to the market conditions that would boost sales or reduce the business’s variable cost.

Calculator

Use the following calculator for Fixed Cost calculations.

Frequently Asked Questions (FAQs)

Q1: What are variable and fixed costs?

Answer: “Fixed costs” are defined as constant expenses regardless of whether a company contributes more or less to the production activity. However, the term “variable cost” refers to a sort of cost that will fluctuate in response to changes in production levels.

Q2: What is the fixed cost per unit?

Answer: Fixed cost per unit, also known as the average cost, refers to the cost of each produced merchandise for all the fixed costs it takes to run a business. It helps businesses determine a price point for their goods & services. It is important because a business can’t generate profit if it is not included in the product’s price.

Q3: What are the 3 elements of cost?

Answer: The three elements of cost are direct material, direct labor, and overhead.

• Direct material is the cost of the raw materials used to produce a product. This would include lumber, steel, fabric, and other materials used in the manufacturing process.
• Direct labor is the cost of the labor required to produce a product. This would include workers who are paid by the hour or by piecework.
• Overhead is the cost of indirect expenses incurred while producing a product. This would include rent, utilities, property taxes, and insurance.

Q4: Is depreciation a fixed cost?

Answer: Depreciation is often thought of as a fixed cost because it is a cost that is incurred regardless of whether or not the business is operating. However, depreciation is a variable cost because it depends on the usage of the assets. In short, the more an asset is used, its depreciation expense will be higher.

Q5: What is the average fixed cost?

Answer: Fixed cost stays unaffected by a business’s output or activity level. This means your average overhead cost will be the same over a set period, no matter if there is a rise or fall in the production level.. For example, if your monthly rent is $2,000 and you produce 100 widgets at $4 each, your average fixed cost per widget is $20 (($2,000 + $400)/100).

Q6: What does Fixed cost include?

Answer: Many items can be included as a fixed cost. The most common type are advertising, office expenses, rent, salaries, and utilities. These costs will not change no matter how much, or little business is done. Other items that we can include are insurance and interest payments.

Q7: What happens to the average fixed cost as output increases?

Answer: As output increases, the average fixed cost decreases. This is because the fixed costs are spread out over a larger number of units of output, so each unit of output has a smaller share of the fixed costs.

Recommended Articles

This is a guide to Fixed Costs. Here we also discuss the introduction and how to calculate the fixed cost. along with advantages and disadvantages. You may also have a look at the following articles to learn more –

1. Fixed Costs Example
2. Absorption Costing
3. Fixed Assets
4. Cost Method