Fixed Cost – What It Is And What's Its Importance

As the name suggests, fixed cost is an expense that does not change very frequently and is recurring. For instance, a company will have to pay a fixed rent every month irrespective of the revenue it generates. This cost to the company might not change under normal business circumstances.

Variable costs are the reverse of fix costs, and they vary as per the company’s activity level. Some examples of variable costs are direct materials, piece-rate labor, and commissions.

Though the fixed cost for the company remains the same, the fixed cost per unit of output might increase or decrease as per the rise or drop in the output or input. For instance, if a company pays a rent of $40,000 and produces 20,000 units of a product, its rent per unit will be $2 ($40,000/20,000). If, due to slow demand, the company produces only 10,000 units, then rent per unit will be $4.

Fixed Cost - What it is and What is its Importance

What Does it Include?

Every company needs to understand the nature of the fixed costs they incur. A high level of the fixed cost usually requires an entity to maintain a higher level of revenue. There are various types of fixed costs that a company incurs. These are Depreciation, Interest Expense, Amortization, Insurance, Rent, Utilities, Salaries, and more.

Moreover, there are various manufacturing overhead costs that are fixed and the amount for a large proportion of the company’s total expenses. Some examples are depreciation of machinery and equipment, salaries and benefits of manufacturing supervisors, factory administration costs, and more.

Accountants face a challenge when they have to assign the fixed cost to different individual output units. Such allocation is important for valuing inventories and the cost of goods sold (COGS). In various manufacturing facilities, a manager assigns fixed costs using machine hours. However, one should consider that the cost rate per machine hour does not reveal how the cost occurs or behaves.

What About the Long-term?

A point to note is that the concept for fixed costs is for the short-run only. In the long-term, all costs will tend to vary, be it rent, salaries, depreciation, maintenance cost, and more.

The fixed cost would also increase or decline if a company goes for restructuring. A company that is looking to pay less in rent would shrink the space and vice versa. The idea is that fixed costs are not as dynamic as the variable cost, and a company can’t avoid them.

Importance of Fixed Cost

  • A firm with massive fixed costs will see a drastic fall in the profit margin if the sales fall. Therefore, such companies stand at a higher chance of seeing a drop in their share prices with a drop in profit margin. In the case of an increase in sales, the same company would witness magnification of profits as increased revenue gets distributed across a constant cost level. A point to note is that a company would show profit only after it recovers all its fixed costs. For instance, if a company has fixed costs of $5000 and essentially no cost per unit sold, then it would be profitable only if it reports revenue of more than $5,000.
  • Fixed costs can result in economies of scale, i.e., a decrease in per-unit costs with an increase in production. For example, assume that it costs $100000 a company to make 100000 toys. The $100000 cost includes $50,000 as administrative, insurance, and marketing expenses (usually fixed costs). If a company decides to produce 200000 units next year, then its total cost increases to $150000. Earlier, it is per unit cost was $1, and now it has come down to $0.75. So, producing each unit is now less expensive and, thus, more profitable for the company.
  • Having a clear understanding of fixed and variable costs helps accountants to prepare the statement of the cost of goods manufactured (COGM). COGM helps a company to calculate the cost of producing the products for a specific time.
  • On the managerial level, assessing such costs helps to make a decision about investing in different assets such as plants, machinery, and so on. For instance, if a company spends big on high direct labor costs, then it may invest in machinery (and increase the fixed component) to lower these high variable costs.
  • It also helps to decide the number of products sold compared to the cost that a company incurs on the fixed equipment. The level of sales at which fixed costs or variable costs that a company incurs in equal is the indifference point.

Final Words

Fixed cost is not the same across all industries. An industry with higher fixed costs generally presents a challenge for newer competitors to enter the space. A capital-intensive industry would incur long-term fixed costs compared to the other businesses. For instance, auto manufacturers, airlines, and companies involved in the drilling operations might incur higher fixed costs.

On the other hand, businesses with a focus on services such as insurance and tax will be more dependent on labor. Therefore, comparing such costs is apt between companies in the same industry and not with different industries.

Must read – Variable and Fixed Costs

Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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