Fixed Cost is the business expenditure that is not affected by how much the business sells. This business expense remains the same for an entire financial period. They are set for a specific span of time and might impact profitability if not managed well.
The other side of fixed costs is variable costs. Cost accounting is the branch of accounting that analyses costs to make it as efficient as possible.
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What is Fixed Cost?
As the name suggests, fixed costs are constant business expenses. The amount tends to be recurring regardless of sales or production.
Some of the common fixed costs are employee salaries, interest, rent, insurance, lease, insurance, utility payments, phone service, advertising costs, amortization, and more.
Fixed costs are an important factor in determining a business’s shutdown point. Shutdown point is the point at which a company’s variable costs are equal to its revenue. If a company’s revenue is below its shutdown point, it will make a loss by continuing to operate.
The higher the fixed costs, the lower the shutdown point.
Variable Cost vs Fixed Cost
| Characteristic | Variable Cost | Fixed Cost |
|---|---|---|
| Definition | A cost that changes in direct proportion to the number of units produced. | A cost that remains the same regardless of the number of units produced. |
| Examples | Raw materials, labor, sales commissions, shipping costs | Rent, property taxes, insurance, depreciation, interest payments |
| Behavior | Increases as production increases and decreases as production decreases. | Remains the same regardless of production levels. |
| Impact on profit | Variable costs are subtracted from revenue to determine the variable cost of goods sold. | Fixed costs are subtracted from the total revenue to determine the profit. |
| Calculation | Variable cost per unit = Total variable cost / Number of units produced | Fixed cost = Total fixed cost |
Fixed Costs in Metrics
Fixed costs are used to calculate a number of very important metrics.
Breakeven Point
The breakeven point can help businesses determine how many units they need to sell to cover their fixed costs and start making a profit. It can also help businesses to set prices and make other decisions about their operations.
Fixed costs are used to calculate breakeven because they are the costs that a business must incur regardless of the number of units produced or sold. So, the number of units sold at the breakeven point is the number of units that must be sold to cover the fixed costs.
The formula for calculating the breakeven point in units is:
Breakeven point = Fixed costs / (Sales price per unit - Variable costs per unit)Operating Leverage
Operating leverage is a measure of how sensitive a company’s profits are to changes in its sales. A company with high operating leverage has a high proportion of fixed costs, so its profits will be more sensitive to changes in sales. A company with low operating leverage has a lower proportion of fixed costs, so its profits will be less sensitive to changes in sales.
Margin of Safety
Margin of safety (MOS) is the amount of sales that a company can lose before it starts making a loss. It is calculated by subtracting the breakeven point from the company’s projected sales.
The formula for calculating margin of safety is:
MOS = Projected sales - Breakeven point
Since fixed costs are used to calculate the breakeven point, they have an indirect effect on a business’s margin of safety as well.
Some Tips to Lower Fixed Costs for Start-ups
Minimizing any business cost will enable business owners to increase business profitability. Here are the ways business entities can lower fixed costs and boost profit margins:
- Tip 1: Subletting business warehouse space other than opting for renters will help in subsidizing costs.
- Tip 2: Conduct research and choose insurance plans that come with lower premiums.
- Tip 3: Opt for refinancing of debt to minimize interest rate.
- Tip 4: Negotiate with leasing business bodies or landlords to fetch lower rent payments.
What is the Impact of Fixed Costs on Business Profitability?
Fixed cost in a business influences the business’s gross profitability. Hence, it is important for the business body to understand and manage them. It will help them enhance business efficiency and increase business profitability.
Businesses with higher production and sales often have a higher fixed cost which can make business profits unstable. If sales drop drastically, a business may not be able to manage them which will impact the overall profit margin.
Managing the fixed cost helps in optimizing the business financial structure, thereby making an apprised decision regarding pricing structure, business finances, and volume of product.
How to Manage Fixed Costs
Fixed costs are an important part of any business, but they can also be a drain on profits. RazorpayX is a business banking platform that can help businesses manage fixed costs more effectively.
With RazorpayX, businesses can get a current account, track invoices, schedule payments, pay tax, apply for loans, and view financial reports, all from one dashboard.
FAQs
What is the difference between fixed and variable costs?
While fixed cost is not affected by the way business performs. Variable cost, on the other hand, changes depending on the rate of production and revenue generation. Cost of labour, materials etc., which are dependent on the volume of the production, are examples of variable costs.
Is depreciation a fixed cost in business?
Yes, depreciation is considered to be a fixed cost in business. This cost remains the same every period and is not impacted by the output. Depreciation is the expense that incurs from the reduction of the value of a tangible asset like machinery or cars that are used during the business.
What is the formula to compute fixed cost?
The formula that will enable business bodies to evaluate the fixed cost-
Fixed cost = Cumulative cost of production – (Number of units manufactured * Variable cost of per unit)
What are business utility expenses? Is this considered to be a fixed cost?
Business utility expenses are the cost incurred from internet, electricity, waste disposal, sewage etc. The utility expenses differ, however, business bodies have fixed-cost contracts where an agreed amount is paid every month.
