Fixed Cost: What It Is and How It’s Used in Business

What Is a Fixed Cost?

A fixed cost is a business expense that normally doesn’t change with an increase or decrease in the number of goods and services produced or sold by the business.

Fixed costs are commonly related to recurring expenses not directly related to production, such as rent, interest payments, insurance, depreciation, and property tax.

Since fixed costs are unrelated to a company’s production of goods or services, they are generally indirect costs. A fixed cost is one of two different types of business expenses that together produce total cost. The other is a variable cost.

Understanding Fixed Costs

Fixed costs don’t change with production levels. Also referred to as fixed expenses, they are usually established by contract agreements or schedules. These are the base costs involved in operating a business. Once established, fixed costs do not change over the life of an agreement or cost schedule.

Fixed Costs on Financial Statements

Fixed costs are allocated in the indirect expense section of the income statement, which leads to operating profit. Depreciation is a common fixed expense that is recorded as an indirect expense. Companies create a depreciation expense schedule for asset investments with values falling over time.

For example, a company might buy machinery for a manufacturing assembly line that is expensed over time using depreciation. Another primary fixed and indirect cost is salaries for management.

Any fixed costs on the income statement are accounted for on the balance sheet and cash flow statement. Fixed costs on the balance sheet may be either short- or long-term liabilities. Any cash used to pay fixed cost expenses is shown on the cash flow statement.

In general, the opportunity to lower fixed costs can benefit a company’s bottom line by reducing expenses and increasing profit.

Factors Associated With Fixed Costs

Companies examine fixed (and variable) expenses when analyzing costs per unit. As such, the cost of goods sold (COGS) can include both types of costs. All costs directly associated with producing a good are summed collectively and subtracted from revenue to arrive at gross profit. Cost accounting varies for each company depending on the costs with which they work.

Economies of scale can also be a factor for companies producing large quantities of goods. Fixed costs can contribute to better economies of scale because they can decrease per unit when larger quantities are produced. That is, per-unit fixed costs drop when they get spread out over a larger number of units.

Fixed costs that may be directly associated with production will vary by company but can include costs like direct labor and rent.

Examples of Fixed Costs

Fixed costs include any number of expenses, including rental and lease payments, certain salaries, insurance, property taxes, interest expenses, depreciation, and some utilities.

For instance, someone who starts a new business would likely begin with fixed expenses for rent and management salaries.

All types of companies have fixed-cost agreements that they monitor regularly. While these fixed costs may change over time, the change is not related to production levels. Instead, changes can stem from new contractual agreements or schedules.

Fixed Cost vs. Variable Cost

Fixed expenses are usually negotiated for a specified period but can't decrease on a per-unit basis when they are associated with the direct cost section of the income statement, fluctuating in the breakdown of costs of goods sold.

Unlike fixed costs, variable costs are costs directly associated with production. Therefore, they change depending on business output. These costs can increase or decrease relative to production levels or sales.

When production increases, variable costs rise. When production decreases, these expenses drop. Variable costs also vary by industry, so it's important for anyone analyzing companies to make comparisons between those that are in the same industry.

Examples of variable costs include the cost of labor, utilities, raw materials, shipping costs, and commissions.

Special Considerations

Fixed expenses can be used to calculate several key metrics, including a company’s breakeven point and operating leverage.

Breakeven Analysis

A breakeven analysis involves using both fixed and variable costs to identify a production level at which revenue equals costs. This can be an important part of cost structure analysis. A company’s breakeven production quantity is calculated by:

$\begin{aligned}&\text{Breakeven Point} = \frac{ \text{Fixed Costs} }{ \text{SPPU} - \text{VCPU} } \\&\textbf{where:} \\&\text{SPPU} = \text{Sales price per unit} \\&\text{VCPU} = \text{Variable cost per unit} \\\end{aligned}$​Breakeven Point=SPPU−VCPUFixed Costs​where:SPPU=Sales price per unitVCPU=Variable cost per unit​

A company’s breakeven analysis can be important for decisions that must be made about fixed and variable costs. The breakeven analysis also influences the price at which a company chooses to sell its products.

Operating Leverage

Operating leverage is a cost structure metric used in cost structure management. Companies can generate more profit per additional unit produced with higher operating leverage.

The proportion of fixed to variable costs influences a company’s operating leverage. Higher fixed costs help operating leverage to increase. You can calculate operating leverage using the following formula:

$\begin{aligned}&\text{Operating Leverage} = \frac{ \text{Q} \times ( \text{P} - \text{V} ) }{ ( \text{Q} \times ( \text{P} - \text{V} ) ) - \text{F} } \\&\textbf{where:} \\&\text{Q} = \text{Number of units} \\&\text{P} = \text{Price per unit} \\&\text{V} = \text{Variable cost per unit} \\&\text{F} = \text{Fixed costs} \\\end{aligned}$​Operating Leverage=(Q×(P−V))−FQ×(P−V)​where:Q=Number of unitsP=Price per unitV=Variable cost per unitF=Fixed costs​

Cost Structure Management and Ratios

In addition to financial statement reporting, most companies closely follow their cost structures through independent cost structure statements and dashboards.

Independent cost structure analysis helps a company fully understand its fixed and variable costs and how they affect different parts of the business, as well as the total business overall. Many companies have cost analysts dedicated solely to monitoring and analyzing a business's fixed and variable costs.

The fixed charge coverage ratio, on the other hand, is a type of solvency metric that helps analyze a company's ability to pay its fixed-charge obligations. The fixed-charge coverage ratio is calculated with the following equation:

$\begin{aligned}&\frac{ \text{EBIT} + \text{Fixed Charges Before Tax} }{ \text{Fixed Charges Before Tax} + \text{Interest} } \\\end{aligned}$​Fixed Charges Before Tax+InterestEBIT+Fixed Charges Before Tax​​

The Bottom Line

A fixed cost is one type of business expense. The other type is a variable cost. Fixed costs are expenses that do not change as production levels change. Rent is one example of a fixed cost. Unlike fixed costs, variable costs (e.g., shipping) change based on a company's production levels.