Fixed Costs

Posted by Professor Cram in Financial Analysis

Fixed Costs

Fixed costs are expenses that are independent of any change in business activity — they remain the same whether the business has $10 or $10 million in revenues. (This should not be confused with variable costs, which are directly proportional to business activities such as production or sales. Variable costs, when combined with fixed costs, yield the total costs for a business.) Examples of fixed costs include rent, utilities, and insurance. Payroll salaries, most forms of depreciation, and capital assets are typically considered to be fixed costs, too.

A quick aside: Don't get too hung up on the word "fixed." Remember, fixed costs are costs that do not vary based on production or sales levels. They are fixed over the short term. Beyond that, they aren't "fixed" forever — we have to expect that given enough time all costs will eventually get higher or lower, not to mention other eventual possibilities like increased headcount, additional facilities, or sale of part or all of the company's assets. This does not change the nature of the costs, though; fixed costs are fixed costs , even if over the long run they change.

Generally, fixed costs include all costs or expenses not included in the cost of goods sold, while variable costs are those captured in the cost of goods sold. Thus, per unit costs like sales commissions and units-of-production depreciation are not fixed costs, nor are items like raw materials and packaging.

In some cases, costs can be partly fixed and partly variable. These are called mixed costs. For example, a factory might have a certain amount of electricity it uses for air conditioning, lighting, etc. even in the absence of any manufacturing activity. This electricity expense would be fixed. Beyond this, additional electricity is needed to run the widget manufacturing machinery as required. The busier the company, the more the widget machinery is run, and the more electricity is used. This additional electricity cost is variable. The total electricity cost is thus regarded as mixed, with both fixed and variable components.

Using fixed costs and variables costs to determine total costs is a function of cost accounting, which is a tool for management decision-making.



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