What Is Fixed Cost, and How is it Used in Business? Definition and Guide

Business expenses are divided into fixed and variable costs. Fixed expenses don't change regardless of the business condition. They are expenditures that your business is committed to, but they aren't related to production volume.

Foundeck in this blog discusses fixed costs definition, their importance, and methods of determining them.

What's a Fixed Cost?

Fixed costs are business expenditures that don't change even after increasing or decreasing product and service sales or production. In most cases, fixed costs are recurring expenses unrelated to production.

Examples of Fixed Cost

1. Rent: A regular fee accrued when leasing a property from a landlord.
2. Insurance: These are costs related to the insurance contract
3. Depreciation refers to an item's overall expense after calculating depreciation. This expense is usually spread out over the item's lifespan.
4. Property tax: If your business owns property, it must pay periodic taxes to the local government.
5. Amortization: Amortization reduces the cost value of intangible assets like patents and also includes loan repayment.
6. Interest expense: This is the cost against borrowings such as loans and bonds. This cost is also referred to as debt expenses.
7. Salaries: Regardless of working hours, salaries are fixed costs paid to business employees.
8. Utility expenses: Business utility costs such as gas, phone, internet bills, electricity, etc., are classified as fixed costs.
9. Advertising and promotional costs: Marketing is a significant expense, especially for small businesses. Most marketing expenses are fixed costs, including brochures, broadcast ads, catalogues, etc.
10. Rental equipment: If your business rents equipment for an extended period, that rental cost is under fixed expenses
11. Legal expense: Expenses related to the company's legal proceedings and regulatory compliance are fixed and, therefore, are considered fixed costs.

Fixed costs and expenses remain constant regardless of production level. Schedules or contractual agreements determine them. Fixed costs represent the fundamental costs required to run a business. Once set, fixed costs remain unchanged throughout the agreement or schedule.

Fixed Expense vs. Variable Costs

Fixed costs are negotiated for a specific period and do not decrease per unit when linked to the direct cost portion of the income statement. They can fluctuate within the breakdown cost of goods sold.

Variable costs are expenses directly linked to production. So, variable costs change based on business output, meaning these costs increase or decrease based on production or sales. When production goes up, variable costs increase; when production decreases, the expenditure falls. These costs differ by industry, making it essential for analysts to compare companies within the same sector.

Variable expenses include:

• Raw materials
• Labor
• Shipping expense
• Utilities
• Commissions

Here is a table showing the difference between fixed and variable costs.

Are Fixed Costs Important?

Fixed costs assist businesses in forecasting their current and future requirements. Here are several ways your business can use fixed costs to gain insights into their production needs and financial interests.

• Profit stability: When your business has high fixed costs, a decline in sales can cause its profit margin to decrease more rapidly than that of a company with higher variable costs.
• Accounting practices: Accountants can include fixed expenses in preparing various stakeholder calculations and reports. A clear understanding of fixed costs is essential for these standard accounting practices.
• Informs business decisions: Fixed expenses per unit can influence business decisions to increase the profit margin.
• Economies of scale: The fixed expense can generate economies of scale, whereby the per-unit production cost decreases as the volume of units produced increases, leading to enhanced profitability.

Tips for Determining Fixed Costs

Here are steps to determine the fixed expenses your business incurs:

1. Add up all your costs

The first step in identifying the fixed cost involves listing all expenses your business incurs. While some of these costs may vary, others remain constant. Obtaining a comprehensive overview of costs relevant to your business is an essential first step in determining fixed costs.

Consider following expenses.

Many business owners miss collecting or overlooking some cost information. You should consider these costs:

• Labor: this is the cost of your workforce
• Maintenance and cost: many overlook this cost since it's hard to predict; however, ensure you account for regular maintenance of equipment, tools, and buildings.
• Permits and legal: If your business needs any state permitting, those expenses should be included in this category.

2. Differentiate the fixed and variable costs

After listing all the manufacturing costs, you should determine the fixed and variable costs. Identifying the fixed costs is easy; you just need to ascertain whether the costs are fixed at a certain amount or vary each month depending on factors.

Begin by opening a new worksheet in your Excel file, then separate the data into two categories: one for the fixed expense and the other for the variable costs. After separating the two costs calculate each column and write the total at the bottom separately. The total of these figures gives you your fixed expenses or the exact cost, no matter the number of units produced.

3. Calculate fixed cost per unit

After establishing the definition of fixed cost, you can compute it. I have singled out this one as we shall consider fixed cost per unit as one of our metrics. To determine this, you must calculate:

 Fixed expense per unit = Total of fixed costs/Total units

This figure will assist you in estimating each fixed cost with each production and identifying the production capacity needed to cover the cost and make a profit.

4. Calculate future fixed expenses

You can use this information to forecast future fixed costs, indispensable for a detailed budget calculation. If the fixed cost is unchanged yearly, one can forecast the price in five or ten years. However, there are future scenarios in which you will have to weigh additional, more sophisticated elements, such as the depreciation of assets.

What Percentage of Company Revenue Should You Allocate to Fixed Costs?

There's no specific formula to determine the percentage of revenue you should spend on fixed costs. This amount varies based on the industry and businesses within the same industry. Manufacturing companies use higher fixed expenses than service companies.

Entrepreneurs should determine the business break-even point when analyzing these costs. This is the sales level where total costs equal all the revenue. Below this point, your business will be operating at a loss, and above that, the company will earn an operational profit.

To reduce your company's break-even point, consider these three strategies:

• Sell high-margin products or services
• Outsource tasks involving fixed expenses to convert them into per unit variable costs
• Review your fixed expenses and reduce as many as possible

Frequently Asked Questions

What is a fixed cost in a business?

These are expenses that stay constant regardless of the business activity. These costs are the opposite of variable costs. You must pay for the fixed costs even when your business is not trading. Fixed expenses tend to recur, including wages, insurance, and leases.

What is the role of fixed cost?

Fixed costs can enhance economies of scale by decreasing per unit cost as production quantities increase. These fixed costs, which might be linked directly to production, vary between companies but may include expenses such as direct labor.

How important do you think fixed costs are to the business owner?

Understanding these expenses and planning your budget effectively to ensure they remain within manageable limits is crucial regardless of future uncertainties. Meeting fixed costs is the fundamental requirement to sustain your business operations. 

Wrap Up

Understanding fixed expenses is vital for businesses because they underpin effective financial planning and tactical decision-making.  Once you understand these expenses, you can budget accurately, calculate business breakpoints, and achieve financial stability. 

This information lets you make business-informed decisions to optimize profitability and navigate financial uncertainties. Employing strategies like selling high-margin products, outsourcing tasks and reviewing fixed costs can further boost financial stability. Mastering fixed costs is vital to positioning your business for long-term success and ensuring operational efficiency. If you have any questions about fixed cost, kindly contact one of our experts here for help.