Fixed Cost: What is it? Why is it Necessary?

Whether a small business owner or an entrepreneur, you must deal with fixed costs. These expenses stay the same regardless of the number of products you create or sell. 

Fixed costs play a critical role in budgeting and cutting down unnecessary spending. Knowing what a fixed expense is and how to calculate it is a smart move for increasing revenue. 

That’s why you must have a solid grasp of fixed costs to control profit margin in the long term. In this article, I’ll break down why fixed costs are essential in accounting and business.

Let’s dive into it and explore major concepts of fixed costs.

What is a Fixed Expense or Fixed Cost?

A fixed expense, also known as a fixed cost, is a business expense that remains constant regardless of an increase or decrease in goods and services. This means the cost doesn’t fluctuate based on the company’s sales and production.

Furthermore, they are considered indirect expenses or overhead costs. This indicates that they’re not directly related to the goods or services. Besides, a company with high fixed costs must earn more revenue to compensate for those expenses.

On top of that, a high fixed expense seeks to foster volume growth instead of a price shift. However, an increase in volume doesn’t impact fixed costs.

For example, your landlord increases the rent for your office. This will increase your fixed cost, but it is not related to your products or services. Thus, it will not change the price of your goods. That’s why it is recommended to increase your sales to cover the fixed expenses.

Lists of common fixed costs:

• Rent or mortgage payment
• Property taxes
• Insurance
• Depreciation and Amortization
• Salaries and Wages
• Vehicle payments
• Loan repayments
• Recurring business license fee
• Equipment lease payment
• Utility bills

Difference Between Fixed Cost and Variable Cost

While fixed expenses remain the same despite production volume, variable costs vary in proportion to changes in output levels. When the volume of goods increases, variable costs rise directly.

Let’s understand with a detailed breakdown of fixed and variable costs

Basis	Fixed Cost	Variable Cost
Definition	Costs that don’t change with the shift of production volume.	Expenses that fluctuate with the expansion and reduction of volume and activity.
Fluctuation	Remain constant every time.	Increase and decrease with the shifting of production levels.
Budgeting	Simple to record as the costs remain the same.	More complex as they vary over time.
Impact on Profitability	When production increases, fixed costs per unit increase, which improves profitability.	Directly impact the cost per unit of production.
Effect on Marginal Cost	Do not affect marginal cost.	Tend to increase marginal cost.

The Standard Fixed Expenses Formula

Now, take a look at the fixed expenses formula so you can easily calculate fixed costs in cost accounting.

The fixed cost formula is:

Fixed Expenses = Total Costs – (Variable Cost per Unit x Number of Units Produced)

Where:

•  Total costs: This refers to the total expenses incurred by the business over a specific period.
• Variable cost per unit: Cost of one additional unit of output.
• Number of units produced: The total quantity of goods or services produced during an accounting period. 

How to Calculate Fixed Cost?

After understanding “what is a fixed expense” and the fixed expenses formula, you are all set to learn how to calculate it.

To find out the exact fixed costs of your business, follow the steps below:

1. List All Expenses

You have to create lists of all expenses that your company pays regularly. Consider dividing annual costs by 12 to find out the monthly spending amount. Always take a look at the bookkeeping accounts and bank transactions to discover expenses and record them in a spreadsheet.

2. Separate Fixed and Variable Expenses

If you only want to calculate fixed cost, separate expenses that don’t change periodically and variable expenses. 

For instance, a chocolate company has expenditures, including raw material $12,000, utility payments $6,000, employees’ wages $38,000, and delivery costs $2,000. Now, record both expenses individually.

Expenses	Fixed Cost	Variable cost
Raw Material		$12,000
Utility Payments	$6,000
Employees Wages	$38,000
Delivery Costs		$2,000

3. Add all Fixed Costs

Now, it’s time to add all fixed expenses that an organization pays every month. This last step is relatively easy to bring about in the value of fixed costs.

For instance, add the amount of utility payments and employees’ wages from the above example of a chocolate company.

$6,000 + $38,000 = $44,000 (Total fixed costs)

To determine the right price per sachet of chocolate, you need to calculate the average fixed cost. 

What is Average Fixed Cost?

Average fixed cost, also called fixed cost per unit, measures the per-unit cost of goods sold. It represents how fixed costs are distributed for each unit made as production volume changes.

To calculate the average fixed cost, you’ll need to identify the total fixed costs and the quantity of output for a particular period.

Formula for average fixed cost:

Average Fixed Costs (AFC) = Total Fixed Costs/Quantity of Output  

Let’s understand with an example:

Yum-Yum Chocolates made 20,000 sachets every month with a fixed cost of $1000. Calculate the per-unit cost of each chocolate pack.

Average Fixed Costs (AFC) = $1000/20,000

                                                               $0.05 (per-unit cost of chocolate)

Understand the Different Types of Fixed Cost

There are four types of fixed costs that are critical to operating a business effectively, as they provide insights into the expense baseline. 

Here is the breakdown of the types of fixed costs.

1. Direct Fixed Costs

Businesses are legally required to pay these expenses. These expenses are directly related to the production process but remain constant if the level of produced goods changes. 

• For example, rent, electricity bills, machinery rental, etc. 

2. Indirect Fixed Costs

These expenses are not related to the production of goods and services, but are necessary for the business operations.

• For example, salaries and wages to the staff members and utility bills for the office.

3. Committed Fixed Costs

Committed fixed costs are the costs that are unavoidable in the business operations. These costs are critical for business functioning and can’t be easily adjusted in a business. As a business owner, you must deal with these financial obligations to maintain production capability.

• For example, property taxes, depreciation, insurance payments, or interest expense for long-term agreements. 

4. Discretionary Fixed Costs

Discretionary fixed costs are often known as managed or programmed costs and referred to as period-specific expenses. They are usually adjusted or eliminated based on management’s decision for a particular time.

• For example, expenses include advertising, marketing, employee training, and product management.

Impact of Fixed Cost on Financial Metrics

As a business owner, the more you know about your business’s fixed costs, the better you will be able to make informed decisions. There are several special considerations about fixed costs that help in relentlessly managing business operations.

Here are some of the key metrics of fixed cost:

1. Break-Even Analysis

The Break Even Point (BEP) is a point at which a company’s total revenue is equal to total expenses. A company uses the break-even point to decide the price at which the product sells to recover expenses. In this situation, an organization is no longer operating at a loss.  

You can calculate the break-even point using the following formula. 

Breakeven Point = Fixed Costs/ SPPU−VCPU

Where:

SPPU= Sales price per unit

VCPU= Variable cost per unit

2. Operating Leverage

Operating leverage is a cost structure metric that measures how revenue growth increases operating income. It indicates the impact of fixed costs on profitability when sales go up or down. With a higher operating leverage, businesses can earn more profit. 

The formula for computing operating leverage:

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

Why is Fixed Cost Important?

Companies with elevated fixed expenses may not earn substantial profits. On the other hand, lower fixed costs are proven beneficial for them. That’s why tracking fixed costs is crucial for operating a business successfully.

Here, I’ve jotted down various benefits of fixed expenses. Take a look at these points…

1. Budgeting and Financial Planning

Fixed costs are predictable and can be managed according to the company’s budget. Therefore, you can create efficient budgets and financial plans by optimizing fixed expenses earlier. Hence, they are beneficial for forecasting and planning. 

2. Pricing and Profitability

By evaluating the fixed costs of your business, you will calculate the break-even point to determine the level of sales needed to recover all your expenses. This information helps you to set the price that generates profit for your business.

3. Strategic Decision-Making

As I already informed you, fixed costs play a critical role in making decisions on business expansion, investment in new equipment, and other strategic initiatives. Thus, they help businesses assess the financial implications for better outcomes.

4. Financial Statements and Accounting

In accounting, fixed costs are recorded in the income statement and the balance sheet. Hence, accurate fixed expenses are needed to analyze cash inflows and outflows within an organization.

5. Operational Efficiency

You can also manage your business operations efficiently by gaining more knowledge about fixed costs. As production increases, fixed expenses are spread to more units, fostering economies of scale and lower per-unit costs. This will increase profitability and improve competitiveness with other brands.

The Bottom Line

Analyzing fixed costs is necessary to adjust your business expenses for efficient financial planning. By keeping these expenses under control, you’ll be better equipped to make informed decisions and support sustainable growth.

Additionally, you can hire accounting experts for accounting services to avoid errors in calculating fixed expenses and preparing a cash flow statement.    

Frequently Asked Questions 

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