Fixed Costs

Introduction

The term “fixed cost” refers to the expenses a company has to pay regardless of its business activities. This cost is constant and doesn’t change with increasing or decreasing revenue, change in the number of services offered, or change in the amount of sales. This is evident from the above-mentioned facts that fixed costs are indirect in nature and are not related to a company’s gross or net production, or any specific good or service. 

Companies generally have two types of costs: one is a fixed cost and the other is a variable cost. A fixed cost is set over a specific time period and doesn’t change with production level or amount of sales. Though it is not directly related to production or sales, it has some effects on profitability. Companies have interest payments, which are considered fixed costs, which affect the net income. Company management usually looks at the effects of fixed and variable costs on the overall business. 

Examples of fixed cost

Fixed costs are usually set up by contract agreements and business schedules. Depreciation is one of the fixed costs that is also considered an indirect cost. A depreciation cost is the amount of capital that is used in a financial year. Common examples of fixed costs are rental leases, mortgage payments, salaries of the employees, insurance payments, property taxes, interest expenses, depreciation costs, and some utility costs. The amount of fixed costs are predictable and contributes to budget balance.

Though these costs may fluctuate from time to time, they do so infrequently and are easily manageable. For example, if the company changes and upgrades the networking facility or the office rent increases, the fixed cost also changes. Fixed costs are typically paid in a fixed amount at regular intervals, such as monthly, quarterly, annually, or biannually. For example, if company insurance is paid bi-annually, the net cost is divided by 6 to get an assumption of the monthly payment. 

Also, car payments, other loan payments, phone bills, childcare costs, tuition fees, gym membership costs, etc. are also included in the fixed cost. As mentioned before, utility costs are considered a fixed expense, but that may vary slightly from month to month. 

Fixed cost formula Introduction

Mathematically, the formula for fixed cost is represented as,

Fixed cost = (total cost of production)-(variable cost per unit * number of units produced)

For example, let’s assume a company produces 20,000 goods every year. During that year, the total production cost, according to the accounts department, was 100,000 rupees. If the variable cost per unit is 3.75 rupees, So, according to the formula, the fixed cost is equal to (100,000-(3.75 * 20,000)) = 25,000.

As a result, the fixed cost is 25,000 INR.

It is of utmost importance to understand that fixed cost is one of the major components of the overall cost of production, the other one being variable cost. In the business world, fixed costs are seen as a phenomenon that hardly changes irrespective of the level of business activity. This fixed cost, however, may change during capacity expansion or unit hive-off. Actually, in the business space, fixed costs often act as constraints to new entrants, especially in capital-intensive industries. 

So, this also works as a competition eliminator in the industry, blocking the way for new aspirants or smaller players. For example, housing leases, insurance fees, rents, and employee fees are very high in such industries, and the small players need to accumulate a large amount of capital to survive in this industry. Expanding the business becomes more difficult and complex in this case, and thus fixed costs eliminate any chance of competition from new players. 

Characteristics of fixed cost

Though fixed costs are considered an indirect cost and don’t relate to the overall sale or service provided, they can have a serious effect on a business. For example, in TV show business or in some sectors of the service industry, the fixed costs are very high. Even if the business runs at a loss, the management needs to maintain a high fixed cost, such as having office space in a very posh area, thus paying a high amount of rent, mortgage, and insurance fees. This is enough to make or break a business. Also, the manufacturing industry has a high fixed cost as it needs ample space, advanced infrastructure, and modern equipment. Usually, the cost of benefits for non-sales and management personnel is included in the fixed cost. Also, fixed costs and semi-variable costs appear as indirect costs in the company’s income statement. 

Conclusion

Knowing one’s fixed costs is critical for generating revenue and expanding one’s business. It helps to balance the budget. One can have a clear idea of how much money he needs to keep aside to pay for fixed expenses every month. It can also help to build a reserve of cash or to establish a line of credit.