What Are Fixed Costs?

Fixed costs are costs or expenses that are not affected by any variations in the number of units produced or sold in the short term. Fixed costs do not depend on the business operations; instead, they are associated with a certain period of time. The total value of fixed costs can be used to calculate other financial metrics, such as the average fixed cost per unit of production.

Highlights/ Key Takeaways

• Costs or expenses that a company incurs outside of its core business operations are known as fixed costs.
• Fixed costs are “fixed” because they do not change with increases or decreases in the number of units produced or sold. Instead, they are set over a specified period of time.
• Total fixed costs of a company can be calculated by summing up all the individual fixed costs. You could also use the total cost of production and the variable cost per unit values to find the total fixed costs.
• If reducing variable costs is not possible, conducting a break-even analysis and minimizing fixed costs can help to lower the total costs of running a business.

What Are Fixed Costs?

The term “fixed costs” is used in finance to describe costs and expenses that remain constant, or “fixed,” regardless of business activities. The fixed costs definition implies that they are unaffected by how much the business produces, - rent and lease payments, insurance, salaries, utility payments, and car lease payments are all examples of typical business fixed costs.

When trying to understand what are fixed costs, keep in mind that they are only one of the two major components of total business costs. The other part is variable costs, which vary depending on the number of units produced and sold. 

As a rule of thumb, higher production and sales volume lead to higher total costs. However, because some costs remain fixed, the percentage increase in total costs will be less than the increase in production and sales. That’s why business owners who want to manage their expenses effectively must take both types of costs into account.

“Fixed costs are “fixed” because they do not change with increases or decreases in the number of units produced or sold. Instead, they are set over a specified period of time.”

Characteristics of Fixed Costs

To qualify as a “fixed cost,” a particular cost or expense must remain constant over a given time period. To help you fully understand the fixed costs meaning, consider the following characteristics of fixed costs:

• Fixed costs stay constant over a specified period of time, regardless of the production output.
• Fixed costs are recurring expenses and need to be paid on a regular basis, - for example, every month, every quarter, or every year.
• Fixed costs are only fixed in the short term; they may change in the long term.
• The average fixed cost per unit of production is inversely proportional to output, meaning the average fixed cost decreases as output decreases and vice versa.
• Fixed costs are typically controlled by top management personnel rather than departmental supervisors.
• Fixed cost allocation to various departments is often made by managerial decisions that use various cost apportionment methods.

Examples of Fixed Costs

Most businesses will incur some of the following typical fixed costs examples:

• Rent or lease payments. When a business rents space from a landlord, it will be charged a fixed recurring amount on a regular basis.
• Property tax. Almost all companies that own properties will need to periodically pay property taxes to the local government.
• Utilities. The cost of many utilities is fixed in nature. Note that some utilities do have a variable element based on usage.
• Interest costs. Many businesses take out loans that are subject to fixed interest.
• Insurance-related costs. Insurance premiums are also recurring fixed amounts as per the contract with the insurance company.
• Depreciated costs. A depreciated cost is the total cost of a tangible asset after accounting for depreciation. This type of cost is usually charged over the useful life of the asset.
• Amortized costs. Amortization is the method of gradually charging an expense of a non-tangible asset throughout its lifetime. Such costs are paid off at the end of the asset’s useful life.
• Salary payments to employees. Salary most often presents a fixed amount paid to employees on a regular basis, as per the contract signed with them.
• Marketing and advertising costs. Some types of marketing and advertising expenses are also considered fixed. These include website hosting costs, allocated budget to social media campaigns, and more. 

Advantages and Disadvantages of Fixed Costs

As with any other type of financial concept, fixed costs have some advantages, - and some disadvantages. Let us take a closer look at the pros and cons of fixed costs.

Advantages of Fixed Costs

• They are constant. Fixed costs are… fixed. They remain constant regardless of the production level of your business, meaning that they won’t increase even if you scale up the production.
• Easier to account for. Because they do not change with the increases or decreases in the production volume, fixed costs are relatively easy to account for.
• Per-unit fixed costs can decrease. As your company starts to produce more, the relative per-unit fixed costs decrease. This encourages the business to produce and sell more.
• Reduced tax liability. Fixed costs lead to a decrease in the company’s net income, which helps to reduce tax liability.
• Eliminate competitors. In some industries, fixed costs are so high that they discourage new companies from entering the market and even eliminate some existing small competitors.

Disadvantages of Fixed Costs

• Per-unit fixed costs can increase. Per-unit fixed costs can increase if a company fails to operate at a certain production rate, leading to reduced profit margins.
• Can be difficult to apportion to different departments. If your company offers multiple products, it can be difficult to find the relationship between the product and the incurred fixed costs. In this case, the allocation of costs can be done based on the profitability of each department.

Why Are Fixed Costs Important?

In general, businesses should aim to keep their fixed costs low to increase their profit margins. Nevertheless, some types of companies will incur higher fixed costs than others, which can impact their overall profitability.

How Do Fixed Costs Impact Profitability?

Certain types of businesses have unavoidably high fixed costs, - for example, a commercial printing operation will use expensive machinery and will require a large (and expensive!) space. The company will have high monthly payments regardless of how many printing jobs it completes.

However, once the company reaches its break-even point (a point at which the fixed costs are recovered), the production costs will be relatively low. Generating operating profits now will be easy, as the variable costs are relatively low. 

Other companies have low fixed costs but higher variable costs. For example, a graphic design company can quickly break even, but the amount of profit generated after won’t skyrocket as it would with high-fixed-cost ventures.

Fixed vs Variable Costs: What’s the Difference?

All types of costs a company incurs can be classified as either fixed or variable. Unlike fixed costs, variable costs are closely related to the number of services or goods produced. They increase as the production volume increases and decrease as the production volume goes down.

Common examples of variable costs include raw production materials, some types of labor costs, commission, packaging, and some types of utility expenses.

Just as with fixed costs, variable costs differ between industries. Nevertheless, the general rule of thumb remains the same: try to keep your variable costs as low as possible.

How to Calculate Fixed Costs

Calculating total fixed costs in accounting is relatively easy, but the result can provide valuable insights into the company’s profitability.

Fixed Costs Formulas

To determine a company’s total fixed costs, you can simply add all the individual fixed costs together:

Total Fixed Costs = Fixed Cost 1 + Fixed Cost 2 + Fixed Cost 3 + …etc.

Alternatively, you can use the company’s variable cost per unit of production and the total cost of production to evaluate fixed costs:

Total Fixed Costs = Total Cost of Production - Variable Cost per Unit x # of units Produced

Once you know the total fixed costs value, you can find the average fixed cost per unit of production by using this formula:

Fixed Cost per Unit = Total Fixed Costs / # of Units Produced

This number can provide additional insights into how fixed cost relates to individual unit production.

Steps to Calculate Fixed Costs

To determine the fixed costs your company incurs, follow these steps:

1. List all the costs your business incurs - both fixed and variable.
2. Determine which costs are fixed and which are variable.
3. Create a spreadsheet with two columns; one - for fixed costs, and one - for variable ones.
4. Find the total fixed costs amount by adding all the entries in the fixed costs column.
5. You can also calculate the average fixed cost per unit of production. Simply divide the total fixed costs value by the total number of units.
6. Finally, you can use total fixed costs to estimate the fixed costs you will incur in the future. For example, if you have the same monthly fixed costs every month, you can project your fixed costs several months out.

Sample Calculation of Fixed Costs

Let us take a look at a numerical example of the fixed costs calculation. 

Suppose Company A manufactures baby blankets and wants to know its average fixed cost per blanket. Company A’s monthly fixed costs are as follows:

Currently, Company A produces 10,000 baby blankets per month. This means that its average fixed cost per blanket can be calculated as follows:

Fixed Cost per Unit = Total Fixed Costs / # of Units =

= $13,970 / 10,000 units = $1.40 / unit

So for every baby blanket the company produces, $1.40 goes to cover fixed costs. If Company A increases production, the fixed cost per unit will go down. If the company slows down production, the fixed cost per unit will increase.

Tips for Reducing Fixed Costs

If you are looking for a way to cut back business expenses, but reducing variable costs isn’t possible, you can try to reduce the fixed costs for your business. Some common ways to do so are:

• Reduce the number of salaried employees on staff.
• Negotiate lower lease payments with your landlord or relocate your business to an area with cheaper rent.
• Sub-lease a portion of your space to recover a portion of rent expenses.
• Shop around to find lower insurance premiums.
• Pay off debt or refinance it to eliminate or reduce interest payments.

Final Word

Every business has both variable and fixed costs. Unlike variable costs, fixed costs remain constant over a period of time and do not fluctuate with changes in production volumes. Understanding exactly what are fixed costs and keeping them as low as possible will help your company to reduce the break-even point and start generating profits faster.