Fixed Cost Examples, Definitions, and Understanding Them for Your Business
When you’re busy setting up your company and learning more about the costs involved with running a business and how they fit into the UK financial year overall, you will come across the notion of fixed costs. For business owners that want to succeed in the long term, knowing what the term means in general, what you’ll need to understand for your firm’s finances, and knowing all about the fixed cost examples you’ll come across is vital.
To help make this happen for your business, we’ve set out a guide on everything you will need to know below.
What is a Fixed Cost?
A fixed cost is a company cost that doesn’t change over the short-term, even with an increase or decrease in the number of goods or services produced or sold. They’re expenses that have to be paid by the company, and are completely independent of any activities that are specific to the business itself.
Fixed costs are generally considered indirect, as they don’t apply to the company’s production services, but there are certain fixed costs that are direct. We have provided examples of direct fixed costs below.
Are All Fixed Costs Considered Sunk Costs?
All sunk costs are considered fixed costs in financial accounting, but not all fixed costs are considered sunk. Knowing which is only one and which is both means knowing the defining characteristic of sunk costs: these are expenses that cannot be recovered. As an example, you might one day return or resell equipment at purchase price, but you cannot expect compensation for the cost of your office’s utilities.
How are Fixed Costs Treated in Accounting?
In accounting, fixed costs are associated with the basic operating and overhead costs of a business. They are considered indirect costs of production, meaning that they don’t fall under the banner of costs incurred directly by the production process (such as parts needed for product assembly), but they do still factor into total production costs. As a result of this, they are depreciated over time instead of being expensed.
Understanding Fixed Costs
You may wish to start at the very beginning in order to understand fixed costs and how they have an impact on your business.
The costs associated with running a business can be broken down into indirect, direct, and capital costs on the income statement and notated as either short-term or long-term liabilities (your company’s financial obligations that are due more than one year in the future). The total cost structure of a company can be split into fixed and variable costs, and these are analysed by cost analysts through various types of cost structure analysis.
Typically, costs will be a key factor in influencing a company’s total profitability.
Fixed costs are normally allocated in the indirect expense section of a business’ income statement which leads to operating profit (the company’s total earnings from core business functions for a given period, minus interest and taxes). Any fixed costs on a company’s income statement will be accounted for on the balance sheet and cash flow statement as well, and may either be short or long-term liabilities. If cash is paid for the expense of a fixed cost, this will also be shown on the business’ cash flow statement.
Generally speaking, the opportunity to lower fixed costs can benefit a company’s bottom line by reducing its expenses and increasing its profit.
Fixed Cost Examples
Here, we have made a list of some of the most common or typical fixed costs you may expect to see, or even to pay for, for your business:
- Amortisation, which is the gradual process of writing off the initial cost of an intangible asset (such as a purchased patent).
- Depreciation, which is the gradual reduction in value of a tangible asset (such as equipment) over time, especially due to wear and tear, and the gradual charging to expense the cost of that asset.
- Insurance, which will be a periodic charge under your contract.
- Interest expense, which is the cost of funds loaned to your business by a lender. However, this is only a fixed cost if the fixed interest rate was incorporated into your loan agreement.
- Mortgage payments, which is a monthly payment made to pay
- Property taxes, which is a tax based on the cost of your business assets and which will be charged to you by the local government.
- Rent, which is a periodic charge (usually monthly) for the use of real estate owned by a landlord.
- Salaries, which are fixed payments made to your employees, regardless of the amount of hours worked.
- Utilities, which covers the cost of electricity, gas, water, your company phones and internet, etc.. It is common for utility payments to have a variable element to them, though it’s more typical for them to be fixed.
It’s important to understand the nature of fixed costs in your business, since you will have to maintain a high level of revenue if you have a high fixed cost to pay, to prevent your company from making a loss. On the other hand, if you only have to pay low fixed costs, you can continue to work and make a profit even if your sales are low. This is particularly useful if you are only just getting started with a small business.
Discretionary Fixed Costs
A discretionary fixed cost is the money you spend for a period-specific cost or a fixed asset. It can also be eliminated or reduced without this having an impact on the reported profitability of your business. They differ from committed fixed costs (the average fixed cost that you will find), because the committed cost obligates you to continue paying a certain amount over a longer period of time.
Compared to an average fixed cost, there are not many discretionary costs that a business will have to take into consideration. However, the ones that exist can be quite large, and as such it’s highly recommended that they are subjected to ongoing review by your management team.
It’s typical for expenditures to have a negative impact on the competitiveness of a business if they’re reduced over too long a period of time, so they should only be considered over a relatively short schedule. On average, this will be between several months and a year. Eventually, these will also have to be renewed, and you may have to make increased expenditures later on in order to make up for the shortfall your business has faced in the past.
As such, a management team is more likely to cut back on discretionary fixed costs when the company is facing a short-term fall in cash. These will then be reinstated as soon as profits and cash flow improve. If costs are continually cut back and never reinstated, it’s common for companies to face issues with reduced brand awareness, declining employee effectiveness, and longer product replacements, depending on the expenditures reduced.
Below, we have made a list of some of the discretionary fixed costs you may need to pay for your business:
- Advertising campaigns
- Employee training
- Investor relations
- Public relations (PR)
- Research and development for specific products
Considerations to Make
Knowing your fixed costs can also help you to calculate several key metrics (measures of quantitative assessment used for assessing, comparing, and tracking performance or production). These include your company’s breakeven analysis and operating leverage.
This involves using both fixed and variable costs to identify production level in which revenue equals costs. This can often be an important part of cost structure analysis, as well as for decisions on fixed and variable costs. It also influences the price at which a company chooses to sell its products.
A company’s breakeven production quantity is calculated using the following equation:
Breakeven Quantity = Fixed Costs ➗ (Sales Price Per Unit – Variable Cost Per Unit)
This is a cost structure metric used in cost structure management, and is influenced by the proportion of fixed to variable costs. Higher fixed costs help to increase operating leverage.
It’s possible to calculate operating leverage with the following formula:
Operating Leverage = [Q x (P – V)] ➗ [Q x (P – V) – F]
- Q = number of units
- P = price per unit
- V = variable cost per unit
- F = fixed costs
Companies can also produce more profit per additional unit produced with a higher operating leverage.
Fixed Costs vs. Variable Costs
The noted opposite or reverse of a fixed cost is the variable cost. These are costs directly associated with production and can therefore change, depending on the output of your business. This means that the amount you will pay will fluctuate over time, and increase or decrease with levels of production and sales.
Sometimes, a business will be deliberately structured to have a higher proportion of fixed costs than variable costs, so more profit is generated per unit produced. This concept only generates outsized profits after all the fixed costs for a period have been offset by sales, however.
Over a long period of time, fixed costs tend to become variable costs. For example, a 10-year lease on a building will be fixed until this time has passed, at which point it comes up for renewal and becomes a variable cost until the decision is made.
Fixed and Variable Costs: Examples Compared
While fixed costs cover regular payments such as rent or mortgage payments, utilities, salaries, and insurance, you can expect variable costs to cover changeable payments. These include things like the price of raw materials, shipping costs, piece rate labour, and commissions.
In the short-term, you should find that there are fewer types of variable costs than there are fixed cost types.
Factors Associated with Fixed Costs
Companies can associate both fixed and variable costs when analysing costs per unit. Because of this, the costs of goods sold (COGS) can include both types of costs. All costs which are directly associated with the production of a company’s goods will be summed up collectively and subtracted from revenue, in order to arrive at a gross profit. Cost accounting will also vary for every business, depending on the costs they’re working with to begin with.
Economies of sale can also be a related factor for businesses that produce large quantities of goods. Fixed costs can often contribute to better economies of sale because fixed costs can decrease per unit when the number of goods produced increases. The types of fixed costs associated with production may vary between companies, but will often include costs like direct labour and rent.
Cost Structure and Management Ratios
As well as financial statement reporting, most companies will also follow their cost structures through independent cost structure statements and dashboards. Doing this kind of independent cost structure analysis helps a company to fully understand its fixed and variable costs, and how they will have an impact on different parts of the business, as well as the business as a whole. Many larger, more established firms will even have hired cost analysts who monitor and analyse the business’ fixed and variable costs.
The fixed charge coverage ratio is a type of solvency metric that helps professionals to work out their company’s ability to pay fixed-charge obligations and expenses. It’s calculated using the following equation:
(EBIT + Fixed Charges Before Tax) ➗ (Fixed Charges Before Tax + Interest)
The fixed cost ratio divides fixed costs by a company’s net sales to work out the proportion of fixed costs involved in production.
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