Fixed Costs

What are Fixed Costs?

Fixed costs are a type of expense or cost that remains unchanged with an increase or decrease in the volume of goods or services sold. They are often time-related, such as interest or rents paid per month, and are often referred to as overhead costs. They are important to attaining more profit per unit as a business produces more units.

Along with variable costs, fixed costs are one of the two components of the total cost of a good or service offered by a business. They are business expenses that do not change as the level of production fluctuates. On the other hand, variable costs are considered volume-related as they change with the output.

Breaking Down Fixed Costs

Let us say, in a milk factory, the monthly payments for the phone lines and security system and the monthly rent for the facilities are fixed costs as they do not change according to how much milk the factory produces. On the other hand, the factory’s wage costs are variable as it will need to hire more workers if the production increases.

An analytical formula can track the relationship between fixed cost and variable cost in management accounting. It is important to know how total costs are divided between the two types of costs. The division of the costs is critical, and forecasting the earnings generated by various changes in unit sales affects future planned marketing campaigns.

Discretionary fixed costs usually come about from decisions made by management to spend on certain fixed cost items. Examples of discretionary costs include advertising, machinery maintenance, and research and development (R&D) expenditures.

Costs of Production

1. Total Fixed Cost

Total fixed costs are the sum total of the producer’s expenditures on the purchase of constant factors of production. The factors of production include capital, land, labor, and enterprise. Examples of fixed factors of production include rent on the factory, interest payment, salary of permanent staff, etc.

2. Total Variable Cost

Total variable costs are costs that vary with production, and they are also called direct costs. Some examples of variable costs include fuel, raw materials, and some labor costs.

3. Sunk Cost

Sunk costs are the costs that cannot be recovered if a company goes out of business. Some examples of sunk costs include spending on advertising and marketing, specialist machines with no scrap value, and other investments whose value cannot otherwise be recovered.

Economies of Scale

Fixed costs are crucial for achieving economies of scale. Economies of scale refer to a scenario where a company makes more profit per unit as it produces more units. Fixed costs only remain unchanged over a certain range of production volumes.

When production increases far enough, such types of costs must be increased. For example, additional machinery may need to be purchased to add production capacity.

Illustrative Example

Let’s take the example of a fixed cost such as a company’s lease on a building. If a company must pay $60,000 each month to cover the cost of the lease but does not manufacture anything during the month, the lease payment is still due in full.

On the other hand, if it produces 500 refrigerators, the cost of the lease is spread over 500 units. If the company sells 1,000 refrigerators, it spreads the fixed cost of the lease over more refrigerators. The company now incurs a lower cost per unit and generates a higher profit.

More Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)® certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

• Cost Allocation
• Projecting Income Statement Line Items
• Remuneration
• Utility Expense
• See all accounting resources