Fixed costs are called as such because it is not dependent on any outside variable. This means that it doesn’t move no matter what the circumstances are outside it. To be specific, it is not dependent on the number of goods or services produced or sold. This means it doesn’t increase or decrease. Thus, it has the word ‘fixed’. This means that these are expenses that will be paid by the company regardless of how many products they sold or how many services they have administered.
However, fixed costs are not permanently fixed. While it is called as such, that doesn’t mean that you will pay the same amount over time. The amount can change but it is called fix in relation to the production of products or the administration of services. So the word ‘fixed’ as in ‘not moving’ may only be applicable for a certain period of time. This is true for loans that are only paid for a specific number of years. With this, fixed costs can be broken down into two other categories: committed fixed costs and discretionary fixed costs. Committed fixed costs are those that are paid for a specific number of years. This can be investments in facilities or equipment. Then, there are also discretionary costs. This pertain to costs in advertising, machine maintenance and research and development. Usually, discretionary costs are considered expensive for the return on investment doesn’t happen quickly.
In operations, fixed costs are considered to be independent from any business activity. It is a type of cost that must be paid regardless of the number of sales your company might have. To compute the total costs of a company, you need to combine fixed costs with your variable costs. The result will be the overall cost or expense that you have to pay. Aside from the computation of costs, fixed costs may also be used in break even analysis where the company looks for the number of products that they have to sell in order to cover their cost. The cost in this computation is usually the fixed cost - a cost that is not dependent on sales.
How to Compute Your Total Fixed Cost
Total Fixed Costs or TFC is the sum of all your fixed costs. To know this, you have to list all of your recurring monthly expenses. List all the equipment that you are currently using that is susceptible to depreciation. This can be a machine in your plant, a car or a computer. All these are subjected to depreciation. Input a depreciation amount and include this in your total fixed cost (TFC).
How to Compute your Average Fixed Cost?
Computing for the total fixed cost can show you how much you are spending. But to know how much money you are earning for every dollar that you spend, you’ll need to compute for average fixed cost.
Average fixed cost refers to the estimate amount of money that you have to spend for every product that you are selling. But this is more than just the materials that you used to create a product. This can also include building rent, utility bills and monthly depreciation of equipment. Why do you need to compute this? Well, you need to know if producing the product is profitable before you produce it. You need to see how much you need to pay and if the sale of the product can cover your expenses. From here, you’ll be able to see if your bottom line is positive and not losing money.
To compute for average fixed cost (AFC), you’ll need your total fixed costs or TFC. Simply divide the TFC with the number of total product units that you have created in a month. The result is your AFC. Easy, right?
Applying Average Fixed Cost to Your Daily Life
You can use the concept of fixed cost in your daily life. Every adult has a specific number of expenses per month: utility costs, car payments, mortgage or monthly rent, healthcare, groceries and transportation costs. Having children can increase this costs and thus result in variable costs such as groceries, healthcare and gas expenses. While these may change from having a growing family, others remain fixed as long as you remain in the same home and have the same car. These are then considered as fixed costs. They remain the same no matter how your family grows.
Applying Average Fixed Cost to your Business
Let’s say you have an ecommerce business. For this, you will need some inventory, warehouse space and some employees. Let’s say you start with 10 employees. As more orders come your way, you will need to hire more employees and get more inventory. With this, your costs will go up. However, there is one thing that stays the same. This is the price that you pay for your warehouse space.
Computing Average Fixed Cost in a Business
Now we cannot compute fixed cost if we keep the situation hypothetical right? We need numbers.
So let’s say that your warehouse requires at least $3,000 in rent for the space and you will also need to rent 2 equipments for the management of your inventory both costing $1,000 each. This means that your total fixed costs will be $5,000 - That’s the cost in rent plus the cost for the equipments.
Now if your warehouse is able to hold 100 pieces of your product, it can be assumed that you are able to sell all of these. You would then need to divide your TFC ($5,000) with the number of products (100). So that is $5000/100 = $500 per piece. $500 is then your average fixed cost per product.
What does this mean to you? This means that you should price the product more than $500 for you to get a return for your investment. In fact, it may be good to price it 2 or 3x. This will ensure that you will get your money back.
PRO TIP: Did you know that the more products you have, the lower your average fixed cost will be? The number of products is the denominator. So if you produce more products with the costs that you have, the average fixed cost will go down.
Fixed Cost in Management Accounting
You may have heard of the concept of fixed cost in economics and you may be surprised that the definition is entirely different. In economics, fixed cost may have other names such as indirect costs or overhead. They are called as such and defined to be time-related. Salaries that are paid on a monthly basis is often referred to as overhead.
Variable costs in economics, on the other hand, are volume related. They are not dependent on time and is instead dependent on quantity produced. You have to note that the number that is the considered is the number of units produced and not the number of units sold. So if a company needs workers to produce a product. The wages become a variable cost. This is because the level of production is directly affected by the number of employees.
Management accounting has a different definition for fixed cost. For management accountants, fixed costs are expenses that does not change based on the activity of a business. This often covers rent and utility bills. It is important to know the distinction between fixed and variable costs in accounting so that you will know which costs to allocate to a particular activity. Ideally, you’ll want to keep your fixed costs down and keep your variable costs higher. This is the reason why companies often hire more contractuals than fixed salaried individuals.
It is very important to note that the usage of the term ‘fixed cost’ vary from management accounting to economics. While there is some truth to the assumption that fixed cost is time-based. This ‘time’ is determined mostly by the management and is not really dependent on the term of the contract alone. Take overhead for example. The costs can vary based on the demand. The company may hire more people when the demand is higher and cut more people when it is lower. Overall, it depends on the decision of the management.
Also, fixed cost is very important in the computation of certain accounting formulas such as that of activity-based costing and the computation of costs of goods sold. Cost accounting practices like activity-based costing will usually allocate cost to the activity to determine profitability while costs of goods sold is usually the combination of fixed cost and variable costs. Fixed costs play a major role in the computation of both.
Examples of Fixed Costs
As mentioned, fixed costs are called as such because they don’t fluctuate as much for every period. This means that no matter how many products you sell, the amount stays the same. Here are some examples of fixed costs that you may incur for your business.
Office Rent or Lease - Most businesses need office space in order to operate. Usually, you will need to pay rent or lease for your office space. This cost usually doesn’t change regardless of whether you are selling or not.
Warehouse Rent or Lease - If you manage a ton of products, you may need to rent a warehouse. While you may choose its size depending on the number of products that you choose to house, the cost for the rent or lease is unaffected by the number of products that you produce.
Equipment Rental - There will be cases where you will need certain equipment for the development of your products. For this, you may also need to pay a fixed amount and thus, it is a fixed cost per month.
Utility Bills - Electricity, Internet and phone bills are usually unaffected by your output. Once you sign a contract with them, you will need to continue to pay them to make your business operational.
Website Costs - Websites may require payments for your ecommerce platform, your domain and hosting. These costs remain even if your website doesn’t make its first sale. Thus, it can be considered as a fixed cost.
Lease or payment for transportation - delivery is essential for businesses as well. You may need to rent a truck or a regular transportation such as a motorcycle or a car to transport your goods. If not, you may need to pay a monthly fee for your transportation if you have a car loan.
Loans - Loans in general is considered as a fixed cost because this means that you need to pay the amount for a specific period of time. The amount is considered ‘fixed’ as long as there is still remaining balance that you have to pay.
Insurance - Insurance can be for health or your property. You may need to fix this amount consistently to stay on the safe side. The costs the insurer is often fixed unless you want to change your plan.
Taxes - Taxes are fixed as well. You need to compute this along with your other costs so that you’ll have an overview of all the fixed costs that you have to pay.
Depreciation - Every building or equipment incurs a depreciation cost each year. This means that it degrades over time. This cost is usually used for repairs and the replacement of the item when it reaches the end of its operational value. This amount is imagined and is usually determined by your accountant.
Salary of Permanent Employees - I mentioned that employee wages can be considered as a variable cost. But it can also be considered as a fixed cost especially if you have a contract with the employee and you have decided that you will pay them a fixed amount in a specific period of time.
Why Learn Fixed Cost?
You need to learn what fixed cost is so that you can see how money goes in and out of your business. The fixed cost acts as an expected expense that you will incur each and every month. With this in mind, you can plan ahead when it comes to the allocation of your money as well as price your products and services so that you’ll still make money out of them.