Fixed Cost

Fixed Cost Definition

Fixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. In other words, it is the type of cost that is not dependent on the business activity, rather it is associated with a period of time.

It can be seen as expenses that are incurred by a company irrespective of the level of business activity, which may include the number of units produced or sales volume achieved. Fixed cost is one of the two major components of the total cost of production. The other component is the variable cost. Examples are monthly rental paid for accommodation, salary paid to an employee, etc. However, please note that such cost is not permanently fixed, but it changes over the period.

Fixed Cost

Fixed Cost Formula

We can derive this formula by deducting the product of variable cost per unit of production and the number of units produced from the total cost of production.

Fixed Cost Formula = Total Cost of Production – Variable Cost per Unit * No. of Units Produced

Examples

  • Leasing office space is a fixed cost. As long the business is operating in the same space, the lease or rent cost remains the same.
  • Utility bills like heating or cooling as per the season changes are another cost that is not affected by the change in business operations.
  • When a company registers itself on a website domain, then a monthly charge is to be paid that remains fixed irrespective of the activities performed on the website.
  • When a company integrates its e-commerce platforms with the website to continue communications and transactions with its customers, there are charges levied for this integration, which are payable monthly.
  • When a business starts its operations, then it leases or rents warehouse space whose charge is payable monthly. This charge does not change even if the business decides to store more or fewer products, keeping in mind the storage and capacity limits. This warehouse rent is a fixed cost.
  • The equipment purchased to produce the products belong to the business once purchased, and it depreciates over time. Depreciation costs are considered as these costs when the company is aware of what time every year the equipment needs to be replaced.
  • Companies hire trucks as per their logistics, and leasesLeasesLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.”read more on trucks are fixed, which do not change depending on the number of shipments the company undertakes.
  • If a business does its financing with the help of bank loans, then loan payments remain the same irrespective of the business’s performance. The loan repayment amount is fixed as long as there is a balance to be paid on that loan.
  • Health insurance for a business is fixed as the recurring costs to the insurer are fixed.

Step by Step Calculation of Fixed Cost

You can download this Fixed Cost Excel Template here – Fixed Cost Excel Template

Example #1

Let us take the example of company ABC Ltd which is a toy manufacturing unit. According to the production manager, the number of toys manufactured in April 2019 is 10,000. The total cost of production for that month as per the accounts department stood at $50,000. Calculate the fixed cost of production if the variable cost per unit for ABC Ltd is $3.50.

Solution:

Given,

  • Variable cost per unit = $3.50
  • Total cost of production = $50,000
  • Number of units produced = 10,000

Cost of production of ABC Ltd for April 2019 can be calculated as,

Example 1.1

= $50,000 – $3.50 * 10,000

FC = $15,000

Example #2

Let us take another example of company XYZ Ltd which is a shoe manufacturing unit. According to the production manager, the production information is available for March 2019 is as follows:

  • Raw material cost per unit is $25
  • Total number of shoe manufacturer is 1,000
  • Labour charge is $35 per hour
  • Time taken to produce a shoe is 30 minutes
  • The total cost of production is $60,000

Calculate the Fixed Cost of production for XYZ Ltd in March 2019.

Solution:

Given,

So, the calculation of variable cost per unit will be –

Fixed Cost Example
Variable Cost per Unit = Raw Material Cost per Unit + Labour Cost per Hour * Time is Taken to Produce a Unit (in hours)

Variable Cost per Unit = $25 + $35 * 0.50

Variable Cost per Unit = $42.50

Therefore, the FC of production of XYZ Ltd for the month of March 2019 can be calculated as,

Example - 2.3

= $60,000 – $42.50 * 1,000

FC = $17,500

Therefore, the FC of production of XYZ Ltd for the month of March 2019 is $17,500.

Please refer given excel template above for detail calculation.

Advantages

Disadvantages

Conclusion

It can be seen from the above explanations that “fixed cost” is very stable and does not change over a period of time. However, a higher volume of production or sales can result in better absorption of fixed cost, which then results in improved profitability. As such, it is important to understand the concept of fixed assets as it can be crucial in the achievement of profitability targets.

Recommended Articles

This article has been a guide to what is a Fixed Cost and its definition. Here we discuss how to calculate fixed cost along with its formula and advantages and disadvantages. You can learn more about accounting from following articles –

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