Fixed cost

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Fixed cost
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Term fixed cost refers to all expenses incurred by a company even when production or sales equals to zero. Fixed costs remain constant over time regardless of the amount of business activity in a given period but are subject to a change in longer time frame (e.g. due to macroeconomic changes, investments in technology, lay-offs). Other factors affecting changes of fixed costs are: changes in business organization, changes in technology applied, sale of manufacturing equipment, decisions to buy or sell portion of company assets, advertising activities etc.

Fixed costs are an inherent part of expenses for a number of businesses, especially in the field of services, including restaurants, cinemas, theatres and hotels.

Origin of fixed cost

Fixed costs include but are not limited to: rent, credit interest, maintenance costs, security and administrative expenses, often salary (in the case of rigid labour markets). Such costs can accumulate over time.

To find out the amount of manufacturing needed to cover fixed costs, a quantitative profitability threshold needs to be calculated from the following variable cost formula\[BEP= {{Fc} \over {(Pu-Vcu)}}\]

where:

  • BEP - quantitative profitability threshold (break even point),
  • Fc - fixed cost,
  • Pu - price per unit,
  • Vcu - variable cost per unit

A level of manufacture (or sales) exceeding calculated threshold will give a profit to a company. It the level is lower, it means operational loss.

Types of fixed costs

Two types of fixed costs can be distinguished:

  • Absolute fixed costs remain absolutely fixed regardless of the level of manufacturing. They do not undergo change with the increase in production. Practically, there are few absolutely fixed costs, e.g. linear depreciation rate.
  • Incremental fixed costs remain stable only up to a certain size of production, which when exceeded, incurs an increase in costs until another production level is reached. Rent of manufacturing space is a good example of such costs.

Following types of fixed cost (or fixed expenses) usually dominate financial statements in many companies:

  • mortgage payments or rent for offices, storage buildings and other facilities,
  • salaries of full time workers (including benefits, insurance etc.).
  • interest payments on debt,
  • insurance (fire, theft, vehicles) - often are required by law,
  • utilities (water, energy) - some of these are variable cost dependent on scale of operation,
  • rental of production and office equipment,
  • salaries of management,
  • services of security agents, legal adviser etc.,

Example of fixed cost analysis

A manufacturing company producing kitchen sets incurs fixed expenses in the amount of 28 500 on a monthly basis. A standard set of kitchen furniture the company produces costs 1 000. Manufacturing costs are at 700. For the company to break even, it needs to sell over 95 kitchen sets a month. Currently the company sells a maximum of 100 sets. The company can increase its profits, if it reduces fixed and variable costs or raises the price of a set.

References

  • Brigham, E., & Ehrhardt, M. (2013). Financial management: Theory & practice. Cengage Learning.
  • Van Horne, J. C., & Wachowicz, J. M. (2008). Fundamentals of financial management. Pearson Education.
  • Petty, J. W., Martin, J., & Scott, D. F. (2002). Financial management: Principles and applications.
  • Mirman, L. J., Samet, D., & Tauman, Y. (1983). An axiomatic approach to the allocation of a fixed cost through prices. The Bell Journal of Economics, 139-151.

Author: Anna Opalińska