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 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.
- 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 leases 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
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.
- 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,
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= $50,000 – $3.50 * 10,000
FC = $15,000
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.
- Total cost of production = $60,000
- Raw material cost per unit = $25
- Labor cost per hour = $35 per hour
- Time taken to produce a unit = 30 min = 30 / 60 hours = 0.50 hours
- Number of units produced = 1,000
So, the calculation of variable cost per unit will be –
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,
= $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.
- Fixed costs continue to remain at the same level throughout a company’s production process unless any major capital expenditure is undertaken. For instance, if a company purchases and installs a machine, post that the company will charge depreciation expense every year irrespective of the level of production.
- It is relatively easier to account for this cost because it does not change in line with the volume of goods produced or sold.
- Although it does not change with an increase in production volume, per-unit fixed cost decreases, which is an encouragement for the production team to produce more;
- Production output and costs typically remain the same for a relevant range of output.
- It reduces the net income a company for the accounting period that results in reduced tax liability, which eventually cascades to cash savings.
- Cost intensive industries act as a barrier to new entrants or eliminate smaller competitors; it discourages new competitors from making an entry into the market.
- One of the major disadvantages is the surge in per-unit fixed cost if a company fails to operate at a certain minimum production rate. If a company has a large number of such costs, then a fall in production or sales volume can squeeze the profit margins.
- It is very tough to find any direct relationship between the product and the fixed cost if the company is into multiple products. As such, at times, the allocation or apportion of cost is done based on the profitability of each division, which can result in wrong financial productivity measurement.
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.
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 –