What is a Fixed Cost?
A Fixed Cost is independent of output and its dollar amount remains constant irrespective of a company’s production volume.
- What is the definition of a fixed cost?
- What are some examples of fixed costs?
- How can you determine whether a cost is a fixed or variable cost?
- What is the difference between fixed and variable costs?
Table of Contents
Fixed Cost Definition
Fixed costs are not linked to production output, so these costs neither increase nor decrease at different production volumes.
Fixed costs are output-independent, and the dollar amount incurred remains around a certain level regardless of changes in production volume.
A company’s fixed costs are incurred periodically, so there is a set schedule and dollar amount attributable to each cost.
Whether the demand for a particular company’s products/services (and production volume) is above or below management expectations, the fixed costs remain the same.
For instance, rent is an example of a fixed cost since no matter whether a company’s sales in a particular period are positive or sub-par — the monthly rental fee charged is pre-determined and based on a signed contractual obligation between the relevant parties.
Fixed vs Variable Cost
Fixed costs must be met irrespective of the sales performance and production output, making them much more predictable and easier to budget for in advance.
Unlike variable costs, which are subject to fluctuations depending on production output, there is no or minimal correlation between output and total fixed costs.
- Fixed Costs → Costs remain the same regardless of the production output
- Variable Costs → Costs are directly tied to production volume and fluctuate based on the output
But in the case of variable costs, these costs increase (or decrease) based on the volume of output in the given period, causing them to be less predictable.
Fixed Cost Formula
A company’s total costs are equal to the sum of its fixed costs and variable costs, so fixed costs can be calculated by subtracting total variable costs from total costs.
Fixed Cost Formula
- Fixed Costs = Total Costs – (Variable Cost Per Unit × Number of Units Produced)
The fixed cost per unit is the total fixed costs of a company divided by the total number of units produced.
Fixed Costs Per Unit Formula
- Fixed Costs Per Unit = Total Fixed Costs ÷ Total Number of Units Produced
The fixed costs per unit are calculated to determine the break-even point, but also to assess the potential benefit of economies of scale (and how it can impact pricing strategy).
Suppose that a company incurred a total of $120,000 in fixed costs during a given period while producing 10,000 widgets.
The company’s fixed cost per unit is $12.50 per unit.
- Fixed Costs Per Unit = $125,000 ÷ 10,000 = $12.50.
If the company scales and produces a greater quantity of widgets, the fixed cost per unit declines, giving the company the flexibility to cut prices for a competitive edge while retaining the same profit margins as before.
Examples of Fixed Costs
Common examples of fixed costs are shown in the chart below.
|Fixed Cost Examples|
Fixed Costs and Operating Leverage
Operating leverage refers to the percentage of a company’s total cost structure that consists of fixed costs instead of variable costs.
- If a company has a higher proportion of fixed costs than variable costs, the company would be considered to have high operating leverage.
- If a company has a lower proportion of fixed costs than variable costs, the company would be considered to have low operating leverage.
As a company with high operating leverage generates more revenue, more incremental revenue trickles down to its operating income and net income.
The downside to operating leverage is if customer demand and sales underperform, the company has limited areas for cost-cutting since regardless of performance, the company must continue paying its fixed costs.
Fixed Costs and Break-Even Point
The break-even point is the required output level for a company’s sales to equal its total costs, i.e. the inflection point where a company turns a profit.
Fixed costs are an input in the break-even point formula, which equals a company’s fixed costs divided by its contribution margin (i.e. sales price per unit minus variable cost per unit).
Break-Even Point Formula
- Break-Even Point = Fixed Costs ÷ Contribution Margin
The greater the percentage of fixed costs within the total costs, the more revenue must be brought in before the company can reach its break-even point and start generating profits.
In effect, companies with high operating leverage (i.e. more fixed costs) take on the risk of failing to produce enough revenue to profit, but more profits are brought in beyond the break-even point.
Companies with business models characterized as having high operating leverage can profit more from each incremental dollar of revenue generated beyond the break-even point.
Since each marginal sale requires fewer incremental costs, having high operating leverage can be very beneficial on a company’s profit margins as long as the amount of sales is adequate and the threshold for minimum quantity is met.
On the other hand, if the company’s revenue declines, high operating leverage could be detrimental to its profitability due to the company being restricted in its ability to implement cost-cutting measures.
Operating leverage is a double-edged sword where the potential for greater profitability comes with the risk of a greater chance of insufficient revenue (and being unprofitable).