Fixed Cost Definition

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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.

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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.

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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.

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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.

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