What is a fixed cost? Learn the fixed cost definition and how to calculate it using the fixed cost formula. Compare fixed vs. variable costs and see fixed costs examples in business.
Updated: 08/05/2021
What is a Fixed Cost in Business?
What Is Fixed Cost?
The fixed cost definition states that businesses incur a cost that does not change positively or negatively with the number of goods sold or services given. Assume a retail business is leasing their space in a mall and has signed a five-year lease; the lease is a fixed monthly cost of $2,000. The store owners will have to pay $2,000 each month regardless of how successful or unsuccessful the business is.
Fixed vs. Variable Costs
There are two major types of costs in business: fixed and variable. As discussed in the previous section, a fixed cost is a cost that does not change regardless of business conditions.
A variable cost is a cost that changes based on the number of goods sold or services rendered. Variable costs can also fluctuate due to market conditions outside of the workings of the business.
The table below shows some examples of each type of cost:
| Fixed Cost Examples | Variable Cost Examples |
|---|---|
| Rent | Interest rate on a corporate card |
| Salaries | Fuel costs for heating |
| Some utilities (internet, cellular) | Raw materials |
| Fixed interest expenses | Shipping costs |
| Insurance | Packaging costs |
How Fixed Costs Affect Business
First, let us imagine a family trying to manage their finances, not knowing how much money they will have by the end of each month to pay bills; this would make life nearly impossible. That is why most individuals and households deal with fixed monthly costs: rent, mortgages, internet, cable, and insurance are all fixed costs that can be easily predicted. However, there are a few costs that people deal with that do change based on market factors, for example, fuel costs for cars and heating. Households learn and plan around those variable costs, so they are prepared.
Businesses use cost structure management to help set prices of goods or services based on the ratio of fixed and variable costs. By understanding what the costs of doing business are going to be, a business can better set their prices to ensure they make a profit. To better understand their costs, businesses will look at three types of costs. Those costs are direct, indirect, and capital.
Fixed Costs
All business costs can be classified as either variable costs or fixed costs. Fixed costs are those costs that do not change based on production levels, while variable costs increase or decrease based on production.
Fixed costs can be assets like buildings and equipment. For example, a beverage company that bottles water is going to need a physical building and an assembly line that includes specialized equipment. If we assume the building and equipment are leased, there is a monthly payment for each of them. The company is responsible for paying 100% of the monthly payments, whether they produce one case of bottled water or 10,000 cases of bottled water.
It is important to note that fixed costs are not always the same. Like the price of anything, they can change - sometimes unpredictably and sometimes on a regular schedule, but they do so based on some other factor, not the level of production. For example, if a lease contract is being renegotiated and a $10,000 per month lease payment is increased to $10,500 per month, fixed costs have risen, but not because of production levels.
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| Type of Cost | Definition | Example |
|---|---|---|
| Direct Cost | A direct cost is a cost that a business can directly attribute to a specific purpose. | A construction firm pays the salaries of the crew who is building a house. The money spent can be directly attributed to the built house and the profits from it. |
| Indirect Cost | An indirect cost is a cost that cannot be directly attributed to a specific purpose or product. | A company spends $100,000 on office supplies. The cost does not directly relate to any specific product or service. |
| Capital Cost | A capital cost is a one-time cost incurred in purchasing land, buildings, or equipment to produce a good or service. | A landscaping company incurs a capital cost when they purchase three new mowers. Capital cost is a one-time cost to help improve the output of the business. |
Fixed Cost Examples
There are several costs that businesses face that fall under the umbrella of a fixed cost. The following is a list of some fixed-cost examples:
- Mortgage or Rent: The cost of leasing a space or paying back a loan for a business.
- Interest costs: The cost of paying back a debt.
- Property tax: Property tax refers to the cost of owning land in a specific region.
- Salaries: The cost of employees on a fixed salary. For example, hourly wages are considered variable since hours can vary.
- Depreciation: Depreciation is the cost of the value of certain assets decreasing over time. For example, company cars value decreases every year.
- Insurance: The cost to insure different aspects of the business.
Fixed Cost Formula
The fixed cost formula is a fundamental economic formula that helps businesses calculate the cost of operation based on fixed and variable costs.
Fixed Cost Formula
Fixed costs = Total production costs - {Variable cost per unit x Number of units produced}
- Total production costs: The entire cost of producing all the units for the given period.
- Variable cost per unit: The variable cost to produce each individual unit.
- Units produced: The total number of individual units produced in a given period.
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How to Find Fixed Cost
The variable cost per unit is how much it costs the company to make each unit; a company calculates this by using the total variable costs incurred and dividing it by how many units they produced. Once a company determines its fixed cost ratio, it uses it to determine the viability of the product being sold at its current price.
The fixed cost ratio represents a ratio that uses the results of the fixed cost formula and divides it by the net sales of the units produced. The ratio will help the company understand the proportion of fixed costs regarding the products sold. If the ratio is too high, the company may need to increase prices.
Example: A business sells 10,000 widgets over the course of a year with a total production cost of $50,000. Each item they sold incurred a variable cost of $1.50 per unit. The company's fixed cost formula would look like this:
$85,000= $100,000 - {$1.50 x $10,000}
Fixed Costs: Short-Term vs. Long-Term
While fixed costs do not continually fluctuate, it does not mean that fixed costs always remain the same. There are two kinds of fixed costs, short-term and long-term; a business must be aware of each one.
| Type of Fixed Cost | Explanation | Examples |
|---|---|---|
| Short-Term | Short-term costs are fixed costs that hold steady for a shorter duration. | Costs with short-term contracts like leases, internet contracts, cleaning contracts, and other fixed expenses that need renewal periodically. |
| Long-Term | Long-term costs are fixed costs that stay the same for very long periods. | A 30 year fixed mortgage on a property, fixed interest rate on a long-term loan; local property taxes are fixed costs that do not change regularly or at all. |
Short-term fixed costs need to be addressed more often but can be ended quicker or renegotiated for a better rate. The liabilities associated with the short-term come when the cost goes up, and the price increases when a new term begins. For example, after a two-year contract, a company can renegotiate its cellular plan or look for other providers. If all rates have gone up, the company's fixed cost may increase.
Long-term fixed costs have the inverse benefits and liabilities of the short-term. The long-term does not require renegotiating costs, which is great if the prices increase. The liabilities include that the company has to deal with the cost for a much longer time. For example, a company signs a 30-year mortgage on their new building. They get a reasonable interest rate which protects them if rates go up. The downside is that the fixed cost is with the business for 30 years.
Fixed Costs vs. Sunk Costs
A fixed cost is a set cost that can be altered or removed to recoup some or all value. An example would be a business that can sell the building they are paying a fixed mortgage for.
A sunk cost is a fixed amount of money that cannot be recouped. The above business is paying advertising costs, but they have nothing to sell to recoup or end those fixed costs.
For example, a new business startup purchases a small office building and advertising space for its new product. If the business began to struggle, they could sell the building to recoup some of the costs of purchasing it. However, in regards to the advertising space, they cannot get anything back on that expense. These are the differences between fixed and sunk costs.
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Average Fixed Cost
The average fixed cost shows the fixed cost associated with each unit produced.
Average Fixed Cost Formula
average fixed cost = fixed costs of production / quantity of output produced
Referring back to the first example for how to use fixed cost formula, the company spent $85,000 on fixed costs to produce 10,000 widgets. The company's average fixed cost would look like the following:
8.5 = 85,000/10,000
Thus the average fixed cost for the company is $8.50 per unit produced.
Business Cost Structure Analysis
Business cost structure analysis considers all the operating expenses and costs and compares them to the profits to help decide how the company should proceed. By considering all the costs associated with production, a company can better understand the pricing of products and services.
Operating Language
Operating language is the terminology used to describe business costs on a day-to-day basis; it can also be referred to as operating costs. There are many expenses associated with the day-to-day operations of a business. A few of these expenses include:
- Direct costs of goods sold (COGS)
- Rent
- Payroll
- Overhead costs
- Raw materials
- Maintenance expenses
Operating costs are deducted from the overall revenue generated from the sale of goods. The difference between the total revenue and the operating costs is the business' operating income.
Economies of Scale
Economies of scale refers to the advantages of a company's cost when the company increases production. This concept ties directly into fixed costs because fixed costs remain the same, so any increase in the production of units will reduce the overall average fixed cost. Let us take a look at the company from the previous two formula examples:
The widget company has an average fixed cost of $8.50 per unit; they produced 10,000 units with fixed costs of $85,000. If the company decides to double its production, the variable costs per unit will increase by $1.50, but the fixed costs will remain the same. That means the average fixed cost will go from $8.50 per unit to $4.25 per unit.
Breakeven Analysis
Breakeven analysis is a straightforward concept in business that essentially tells the business the number of units they need to sell in order for them to cover their costs. Breakeven analysis looks at fixed and variable costs to calculate the exact number of units they need to sell so the company does not lose money.
Lesson Summary
A fixed cost is a cost that a company incurs that remains fixed and does not fluctuate based on outside factors, while a variable cost is a cost that can fluctuate constantly and cannot be predicted.
| Fixed Cost Examples | Variable Cost Examples |
|---|---|
| 30-year mortgage | Fuel costs for heating |
| Salaries | Hourly labor |
| Property taxes | Raw materials |
Businesses use the fixed cost formula to determine the number of fixed costs during a given period regarding unit production, which is used to determine the average fixed cost. The formula is written like the following:
Fixed costs = Total production costs - {Variable cost per unit x Number of units produced}
The average fixed cost shows the company how fixed cost is associated with each product they produce. This number helps to determine their economy of scale by looking at the costs associated with increasing production. Fixed costs will decrease as production increases.
The fixed cost ratio is a proportion between the fixed costs and the number of units sold that a business will use to determine whether a price point is accurate or production needs to change. Businesses use the data from fixed and variable costs to determine their short-term and long-term viability and the price points of the units they produce.
Formula for Fixed Costs
As mentioned above, fixed costs are one part of the total cost formula. The formula used to calculate costs is FC + VC(Q) = TC, where FC is fixed costs, VC is variable costs, Q is quantity, and TC is total cost.
It is important to understand that variable costs, as opposed to fixed costs, are those costs that change based on the amount of product being produced. For example, our bottled water company has a variable cost in bottles. The more bottled water they produce, the higher their cost associated with bottles will be.
If we return to our bottled water company and say that the monthly lease for their building is $10,000 and the monthly lease for the equipment is $15,000, then our total fixed costs are $25,000. If the cost of labels, bottles, packaging, and water that go into each case of bottled water is two dollars, then our variable costs are two dollars. At this point, we have our cost structure as $25,000 + $2(Q) = TC.
Now, each month, total costs can be calculated by plugging actual quantity produced into the cost function, which gives us $25,000 + $2(30,000) = TC. We can then get our total costs (TC) by doing the math: $25,000 + $2(30,000) = $85,000.
With this information, per unit total costs can be calculated by dividing the quantity produced into the total cost. Based on our sample month above, per unit total costs would be $85,000 / 30,000 = $2.833.
Lesson Summary
The implications of fixed costs will become clearer when you've learned about overhead costs, variable costs and the total cost formula. For the purposes of this lesson, the important thing to remember is simply fixed costs are costs that do not change based on production, such as assets like buildings and equipment.
Learning Outcomes
Following this video lesson, you will be able to:
- Define fixed costs
- Identify examples of fixed costs
- Explain how fixed costs fit into the total cost formula
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Video Transcript
Fixed Costs
All business costs can be classified as either variable costs or fixed costs. Fixed costs are those costs that do not change based on production levels, while variable costs increase or decrease based on production.
Fixed costs can be assets like buildings and equipment. For example, a beverage company that bottles water is going to need a physical building and an assembly line that includes specialized equipment. If we assume the building and equipment are leased, there is a monthly payment for each of them. The company is responsible for paying 100% of the monthly payments, whether they produce one case of bottled water or 10,000 cases of bottled water.
It is important to note that fixed costs are not always the same. Like the price of anything, they can change - sometimes unpredictably and sometimes on a regular schedule, but they do so based on some other factor, not the level of production. For example, if a lease contract is being renegotiated and a $10,000 per month lease payment is increased to $10,500 per month, fixed costs have risen, but not because of production levels.
Formula for Fixed Costs
As mentioned above, fixed costs are one part of the total cost formula. The formula used to calculate costs is FC + VC(Q) = TC, where FC is fixed costs, VC is variable costs, Q is quantity, and TC is total cost.
It is important to understand that variable costs, as opposed to fixed costs, are those costs that change based on the amount of product being produced. For example, our bottled water company has a variable cost in bottles. The more bottled water they produce, the higher their cost associated with bottles will be.
If we return to our bottled water company and say that the monthly lease for their building is $10,000 and the monthly lease for the equipment is $15,000, then our total fixed costs are $25,000. If the cost of labels, bottles, packaging, and water that go into each case of bottled water is two dollars, then our variable costs are two dollars. At this point, we have our cost structure as $25,000 + $2(Q) = TC.
Now, each month, total costs can be calculated by plugging actual quantity produced into the cost function, which gives us $25,000 + $2(30,000) = TC. We can then get our total costs (TC) by doing the math: $25,000 + $2(30,000) = $85,000.
With this information, per unit total costs can be calculated by dividing the quantity produced into the total cost. Based on our sample month above, per unit total costs would be $85,000 / 30,000 = $2.833.
Lesson Summary
The implications of fixed costs will become clearer when you've learned about overhead costs, variable costs and the total cost formula. For the purposes of this lesson, the important thing to remember is simply fixed costs are costs that do not change based on production, such as assets like buildings and equipment.
Learning Outcomes
Following this video lesson, you will be able to:
- Define fixed costs
- Identify examples of fixed costs
- Explain how fixed costs fit into the total cost formula
To unlock this lesson you must be a Study.com Member.
Create your account
Additional Activities
Identifying Fixed Costs In Real Life - A Business Case:
In this business case, you are a seasoned professional accountant acting as a consultant. This lesson extension will enable you to apply your knowledge of fixed costs in order to identify them and provide pertinent recommendations to management.
Case:
You receive a call on Monday morning from a new client, Yummy Foods Enterprise. Yummy Foods is a small business that specializes in preparing packaged gourmet dishes that are sold as frozen meals in grocery store chains across the state of Illinois. The Chief Financial Officer of Yummy Foods is the one who called you.
"We have a major problem. Our head cost accountant left the company today, and we don't have anyone that can replace him. I have too many things to do, so I need your help. The head accountant wanted to calculate our break-even point, and for that, he needed to separate our fixed costs from our other costs. I attached a list of our costs below. Can you please identify which costs are fixed so that we have proper documentation for the intern accountants to understand? Also, can you give me your opinion on whether it is better for a small company like us to have a higher or lower proportion of fixed costs? Our sales still vary like crazy every month, but the board wants us to be profitable at all times. Thanks!"
| Cost Items | Fixed Cost? (Y/N) |
|---|---|
| Rent paid for factory | |
| Hourly wages paid to workers (we can ask them to work as much or as little as we want) | |
| Property taxes for office building | |
| Lease Payments on Machinery | |
| My salary (i.e., CFO) | |
| Ingredients purchased from suppliers |
Solution:
| Cost Items | Fixed Cost? (Y/N) |
|---|---|
| Rent paid for factory | Yes |
| Hourly wages paid to workers (we can ask them to work as much or as little as we want) | No |
| Property taxes for office building | Yes |
| Lease Payments on Machinery | Yes |
| My salary (i.e., CFO) | Yes |
| Ingredients purchased from suppliers | No |
It is generally advisable for small businesses that want to remain profitable at all times to have a lower proportion of fixed costs. This is because the fixed costs will be incurred regardless of the number of units produced and sold. Therefore, a lower proportion of fixed costs will result in lower total costs when sales are low, which in turn increases the probability of a profitable operation.
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What is a Fixed Cost? | Average Fixed Cost Examples & Formula
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