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 - 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.
Advantages of Fixed cost
Fixed costs have several advantages. Firstly, they provide a degree of certainty to the business by allowing them to budget and plan in the long-term. Secondly, they allow the company to absorb short-term fluctuations in sales and production, providing a more stable operating environment. Thirdly, fixed costs may enable some cost savings in the long-term by allowing the company to negotiate better deals with suppliers and employees. Fourthly, fixed costs can aid in reducing the risk of unexpected costs, which can be especially beneficial for companies with high levels of debt. Finally, fixed costs can provide a source of revenue for the company if sales fall below the set amount of fixed costs.
Limitations of Fixed cost
- The first limitation of fixed costs is that they are not flexible. Companies are not able to adjust to changes in market conditions or demand. This can lead to significant losses if the demand for the product decreases or if the cost of production increases.
- Fixed costs can also be difficult to accurately predict and can be subject to fluctuations over time. This can lead to significant financial losses if the actual costs are higher than expected.
- Fixed costs can also be difficult to manage and control. Companies must carefully consider fixed costs when making any decisions about operations or investments, as these costs will remain no matter what happens.
- Finally, fixed costs can be a burden on a company’s profitability. This is because fixed costs are not directly tied to any production or sales activity, meaning that they are not offset by any revenues.
- Marginal costing: This method of costing involves only variable costs, as opposed to fixed costs, in the cost of production. It is also referred to as variable costing and is used to determine the cost of a single unit of output.
- Absorption costing: This approach takes into account both variable and fixed costs when determining the cost of production. It is used to ascertain the cost of a single unit of output as well as the total cost of producing the entire output.
- Activity-Based Costing (ABC): This is a costing system that assigns costs to activities that are used to produce a product. It is a more detailed and complex method than marginal or absorption costing and assigns costs to specific activities instead of products.
- Throughput costing: Throughput costing is a form of absorption costing that focuses on the costs associated with throughput, which is the rate at which a product is being produced. It assigns costs to products based on the amount of resources it uses in the production process.
In conclusion, fixed cost is an important concept in cost accounting, and there are several other approaches related to it, such as marginal costing, absorption costing, Activity-Based Costing (ABC) and throughput costing. Each of these approaches has its own advantages and disadvantages, and it is important to carefully consider which approach is best suited for the particular situation.
|Fixed cost — recommended articles
|Step fixed cost — Committed cost — Cost oriented pricing — Baumol model — Normal cost — Marginal pricing — Differential costing — Differential cost — Tooling costs
- 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