Keeping fixed costs under control is one of the top priorities for CFOs, especially for reaching the break-even point. Managing fixed costs also helps them budget, forecast, and reduce unnecessary fixed business expenses.
For example, businesses typically spend up to 70% of the total expense on salaries or fixed labor costs. These companies will likely struggle with cash flow and financial sustainability when they can’t control similar fixed financial obligations. Optimizing fixed costs enables them to improve profit margins and economies of scale.
This article walks you through the basics of fixed costs, their importance, how to calculate them, types of fixed costs, and how to show them in financial statements.
What is fixed cost?
Fixed costs are business expenses that remain the same regardless of the amount of goods and services an organization produces or sells. These recurring costs don’t change with the revenue a business generates.
Common examples of fixed costs are:
- Property tax
- Monthly rent
- Phone service
- Utility bills
- Interest payments
- Equipment lease payment
- Business insurance premiums
- Employee salaries and wages
- Recurring business license fees
Fixed costs are also known as overhead or indirect costs, as they aren’t directly related to the production cost of goods and services. That’s why fixed costs appear as operating expenses under an organization’s income statement.
Fixed cost, along with variable cost, constitutes the total business expense. Variable costs are production expenses that fluctuate depending on a company’s production or sales volume. For example, variable costs decrease when a company’s manufacturing unit produces fewer units and uses fewer raw materials.
The role of fixed costs in business
Understanding fixed costs enables business owners to predict upcoming expenses, create an accurate business budget, make better investment decisions, and control operational costs.
1. Expense forecasting
Fixed costs are expenses that don’t change with production volume. As a result, businesses can forecast necessary costs and budget accordingly.
Imagine a manufacturer paying ₹ 83,000 monthly to rent a manufacturing facility. This cost is a fixed financial obligation for the manufacturing business. Calculating all fixed costs like this helps the company understand how much sales they must make to cover fixed business costs and reach financial stability.
2. Investment decision-making
Organizations contemplating an expansion analyze fixed costs before making new investments. This financial analysis helps them create the pricing strategy and production plan necessary for meeting the overhead expenses. Businesses can easily measure the new venture’s economic sustainability and profit potential with the analysis.
Imagine a business selling smartphones at ₹ 16,000 and investing ₹ 40 lacs to open a new manufacturing plant. Calculating all fixed expenses and margins per smartphone helps them evaluate the minimum number of smartphones they must sell to make profits.
3. Cost control and management
A fixed cost structure enables business owners to adjust variable expenses and better manage costs. For example, an organization expecting to spend more on raw material sourcing during the next fiscal year can negotiate rental agreements to reduce fixed business costs. This cost optimization is vital for efficient resource allocation and improving financial stability.
Now, let’s explore the importance of fixed costs in business operations.
Why are fixed costs important?
Fixed costs provide businesses with crucial insights for financial planning. For example, companies with skyrocketing fixed expenses may not make substantial profits. On the other hand, lowering fixed costs can help them reduce expenses and increase profits.
Learn why tracking fixed expenses is essential for optimizing different business finance elements in this section.
1. Profit stability
Organizations with more fixed costs than variable expenses experience a high fixed cost structure or high operating gearing. These companies are constantly under pressure to achieve a certain sales level to meet the total fixed expense amount. Even the slightest profit volatility adds to the operating risk. Businesses with lower fixed costs can efficiently reduce expenses and increase profits.
2. Break-even analysis
Analyzing break-even points helps companies understand when their production cost will equal revenue, after which they will start making profits. They calculate the break-even point by dividing total fixed costs by the difference between revenue and variable costs per product unit.
Break-even point = Fixed costs of the total number of units produced / (Revenue – variable cost per unit)
The break-even point shows the total number of units organizations must sell to cover fixed costs and become profitable. Businesses with lower fixed costs have a lower break-even point, meaning they can become profitable faster.
Imagine a small candle manufacturing business spending ₹ 20,000 monthly on fixed costs. The variable cost of packaging and ingredients is ₹ 7 per candle.
If they generate a revenue of ₹ 15 per candle, their break-even point is 20,000/(15-7)=2,500. They must sell 2,500 candles every month to cover fixed expenses. Lowering the fixed cost will help them reach the break-even point faster.
3. Economies of scale
Companies with efficient production processes do not only create economies of scale but also lower per-unit fixed cost, which in turn boosts profitability. The increase in production enables them to produce more items and spread the fixed expense over more outputs.
Imagine a business spends ₹ 5,000 worth of fixed expenses to produce 1,000 pens at the per unit cost of ₹ 5. If they decide to make 2,000 pens, the cost per unit reduces to ₹ 2.5, and that happens because the fixed business cost doesn’t fluctuate with production volume.
4. Operating leverage
Fixed and variable cost analysis is vital to finding operating leverage, which measures if a company’s operating income increases when sales revenue grows.
The relation between operating leverage and fixed business expense is proportionate. Companies with higher fixed operating costs experience high operating leverage as they use more fixed assets. However, their profit significantly changes when revenue fluctuates.
On the other hand, the profit change remains relatively lower for organizations with lower operating leverage.
Examples of fixed costs
Below are some common examples of fixed costs for businesses.
- Depreciation is the decreasing cost of a tangible asset (like production equipment) over its useful asset life due to obsolescence, use, and wear and tear. It’s a fixed cost because the writing-off value remains unchanged over the asset’s life.
- Amortization refers to scheduled debt payments and pre-determined installments for intangible assets like patents. Imagine an organization paying ₹ 10 lacs to buy a patent that expires in ten years. The accounting team will show ₹ 1 lac annually as amortization expense over the next ten years.
- Insurance premium is a company’s periodic premium under an insurance contract. Common examples include employee insurance, machinery insurance, and transport vehicle insurance.
- Interest expense or debt expense companies pay toward borrowings like loans, credit lines, convertible debt, and bonds. Interest-related costs remain fixed when the loan agreement mentions a fixed interest rate.
- Property tax is the ad valorem real estate tax a local government levies on a business based on its total assets. Companies pay this fixed tax yearly.
- Rent is the amount companies pay landlords for using their real estate properties. This amount remains fixed and doesn’t change depending on the production or sales volume. Some businesses also pay fixed equipment rental costs when they rent production tools.
- Salaries refer to the fixed compensation an organization pays its employees. Employee salaries remain the same regardless of work hours.
- Utility expenses are mostly fixed book costs that companies pay for electricity, phone, gas, internet, and telephone bills.
- Legal expenses include court costs and solicitor fees that organizations bear while obtaining legal advice, starting legal proceedings, or initiating claims.
- Advertising expense refers to the amount a business spends on promotional activities, such as marketing campaigns, advertisements, surveys, giveaways, and focus group studies.
Now, let’s explore how these fixed expenses may fall into different categories depending on the nature of the cost.
Types of fixed costs
Fixed costs are of four types: direct fixed costs, indirect fixed costs, discretionary fixed costs, and committed fixed costs.
1.Direct fixed costs are expenses a business must pay during goods and services production and delivery. This cost doesn’t fluctuate with the number of units produced.
For example, a smartphone company’s production facility rent remains the same regardless of whether they increase or decrease the number of smartphones they make every month.
2. Indirect fixed costs are business expenses unrelated to goods production or service delivery. For example, employee salary remains fixed but isn’t directly associated with the production output.
3. Committed fixed costs or capacity costs are multiyear financial obligations companies bear to maintain their production capacity. These costs remain unchanged as businesses can’t avoid them while using their existing production capabilities to create and sell products.
For example, property taxes, depreciation, or insurance expenses are committed fixed payments and result from long-term agreements.
4. Discretionary fixed costs, also known as managed or programmed costs, refer to period specific costs resulting from the management’s policy decisions.
Examples include spends related to advertising, marketing, employee training, research, and product development. Managers review these costs annually and reduce or increase them according to the company’s budget.
Understanding these classifications helps businesses analyze and optimize existing fixed business expenses.
Characteristics of fixed costs
Below are some of the features of fixed business costs.
- Constant: Fixed costs don’t fluctuate or change with the goods an organization produces.
- Recurring: Companies must pay fixed expenses every month, quarter, or year, depending on the agreement. For example, an organization must pay monthly salaries to employees or annual insurance premiums.
- Can vary per unit basis: Fixed expenses may increase or decrease on the income statement based on the total number of units a company produces. For example, when a manufacturing company produces more units, the fixed cost per unit decreases.
- Established by agreements: Fixed costs result from agreements and contracts that remain valid for the entire agreement.
Let’s explore how to use the fixed cost formula to calculate fixed business expenses.
Fixed cost formula
Start by multiplying the variable cost per unit by the total number of units produced during a period. Now, subtract the value from the total production cost to find the fixed cost.
Imagine a laptop manufacturer named ZenX Private Limited producing 500 laptops every year. The variable cost of each computer is ₹ 1,000. They spent ₹ 8,00,000 on making 500 laptops this year.
In this case, the fixed expense is = 8,00,000 – (1,000 x 500) = 8,00,000 – 5,00,000 = 3,00,000
Businesses can also use a tally method to add all fixed expenses during a period and calculate fixed business expenses.
How to calculate the fixed cost?
Organizations can follow the steps below to calculate fixed costs by separating them from variable expenses.
1. Make a list of all costs
This step involves creating a list of annual fixed and variable expenses your organization pays. Consider dividing yearly costs by 12 to find the monthly spend. Now, list out all payments in a spreadsheet.
For example, imagine a laptop manufacturer named ZenX Private Limited spending ₹ 48 lacs annually, including fixed and variable expenses. They can list the costs that constitute the monthly spend of 4 lacs.
2. Separate fixed and variable costs
Now, it’s time to separate fixed and variable expenses — business costs that remain the same or fluctuate with production or sales. The idea is to find and itemize costs that remain fixed for a period.
For example, ZenX Private Limited spends ₹ 8 lacs on employee wages, ₹ 12 lacs on raw materials, ₹ 10 lacs on production facility rent, ₹ 2 lacs on delivery costs, ₹ 3 lacs on packaging supplies, and ₹ 5 lacs on utility payments.
Here’s what the cost separation looks like for them.
Production facility rent
3. Add all fixed costs
This step is relatively easy and involves adding all fixed costs. For example, here’s what the data looks like for ZenX Private Limited.
The company spends ₹ 23 lacs annually on fixed business costs.
Production facility rent
Fixed cost in financial statements
Cost analysts evaluate fixed and variable expenses to understand a company’s total cost structure and profitability. It is crucial to understand how fixed payments appear in financial statements.
Fixed expenses typically appear in the indirect expense section of an income statement. Organizations also record these expenses on the balance sheet and under operating activities in cash flow statements.
These expenses result from short-term or long-term liabilities. For example, companies purchasing machinery create a fixed expense schedule for depreciation over the asset’s useful life. The aim for any organization remains to analyze fixed expenses, lower them, and improve profitability.
Variable cost vs. fixed cost
Variable expenses fluctuate with the organization’s production output. In contrast, fixed cost doesn’t change with production or sales volume.
Variable costs change depending on a company’s business activity and production levels. These costs proportionately increase or decrease with production volume. Examples include delivery costs, credit card fees, piece-rate labor, raw material costs, and sales commissions.
Some costs may be fixed for some enterprises but variable for others. For example, a food truck company’s fuel cost remains fixed as the fuel expense doesn’t change with the food quantity it sells. However, a parcel shipping company’s fuel cost remains variable as their spending on fuel depends on the number of packages they deliver daily.
Fixed costs are unavoidable business expenses that don’t change with increasing and decreasing production or sales levels. These costs may change in the future but remain the same for a period. Examples include rent, employee salaries, insurance, and debt payments.
Some enterprises may also have semi-variable costs which combine fixed and variable expenses. Imagine a vehicle rental business charging per-mile charge along with a base rate. Hiring vehicles from this company means paying the base cost (which remains fixed) and per-mile cost (which varies depending on the distance).
Variable costs are expenses that change when a company increases or decreases production levels.
Fixed costs are business expenses that remain the same regardless of the sales or production levels.
Also known as
Variable costs are also known as direct costs or prime costs.
Fixed costs are referred to as supplementary, indirect, and overhead costs.
Sales commissions, credit card fees, and raw material cost.
Rent, salary, insurance premium, property taxes, and debt payments.
Variable expenses change depending on the production volume.
Fixed expenses don’t change for a period and may change after that.
Application of fixed and variable costs
Analyzing and evaluating fixed and variable expenses helps businesses ensure their companies’ financial well-being and profitability. Learn how to apply fixed and variable business costs in this section.
- Pricing strategy: Fixed expenses provide enterprises with a base cost level that they must cover to stay in business. On the other hand, variable expenses help them decide the final unit cost of products they sell. Companies can increase and reduce the product price depending on the fluctuating variable costs.
- Cost control: Variable and fixed expenses also help companies formulate cost control strategies. Organizations negotiate existing vendor contracts and agreements or find alternatives to minimize fixed expenses. Similarly, they also optimize production processes and aim for bulk discounts to reduce variable costs.
- Loan and financing: Financial institutions, banks, and lenders analyze a company’s fixed-charge coverage ratio (FCCR) to evaluate whether the earnings are sufficient to meet fixed expenses. A high FCCR ratio indicates an organization has adequate revenue to meet fixed business costs.
Now, let’s look at the role of fixed cost in determining an enterprise’s profitability.
How does fixed cost impact profitability?
Organizations analyze their gross profit and net profit to measure profitability. Gross profit is the difference between total revenue and total cost of goods sold (COGS). It shows a company’s ability to turn every penny of revenue into profit.
COGS includes business expenses necessary for producing goods, including raw materials and employee wages. However, it doesn’t consider other expenditures like rent and insurance premiums. Any changes in fixed or variable costs impact COGS, influencing the gross profit.
It’s worth noting that fixed expenses affect profitability more than variable ones. For example, businesses with significantly higher administrative costs will have less profit regardless of the number of units they sell.
Tools and resources
Accounting teams use different tools to track, analyze, and optimize fixed business costs. Below are tools businesses must have in their arsenal.
- Accounting software: Accounting tools are necessary for documenting and categorizing financial transactions and creating financial reports. These software solutions aid businesses with spend tracking, general ledger entry, and report generation.
- Cost management software: Cost management systems enable accountants to monitor organizational cost structures, find areas for improvement, and optimize business expenses. Companies can also use these tools to forecast and budget future cost trends.
- Enterprise resource planning (ERP) software: ERP systems provide enterprises with insights into integration among different business functions and departments. Accounting teams use ERP solutions to analyze financial data from various business units and create accurate financial reports.
- Expense tracking software: Expense tracking tools make it easier for accountants to digitize fixed expense receipts and create reports.
- Business intelligence (BI) tools: These software solutions enable organizations to visualize vital financial metrics, discover cost-saving opportunities, and make informed financial decisions.
Read More: 10 Best Expense Management Software
Fixed business expenses are necessary costs that businesses must pay regardless of their sales or production activities. These costs stay the same during a financial year. Analyzing these expenses allows enterprises to reach break-even points, boost operating leverage, achieve economies of scale, and improve profitability.