Fixed cost definition
/What is a Fixed Cost?
A fixed cost is a cost that does not increase or decrease in conjunction with any activities. It must be paid by an organization on a recurring basis, even if there is no business activity. The amount charged to expense tends to change little from period to period. Fixed costs tend to be incurred on a regular basis, and so are considered to be period costs. The concept is used in financial analysis to find the breakeven point of a business, as well as to determine product pricing.
Examples of Fixed Costs
Many costs can be classified as fixed costs, including the following:
Facility rent. The rent on a building will not change until the lease runs out or is re-negotiated, irrespective of the level of activity within that building.
Salaries. This is a fixed amount of compensation that is paid to the recipient, irrespective of the number of hours worked. It is typically only changed once a year, as part of an annual performance review.
Insurance. The amount of insurance paid is usually fixed on an annual basis, so that the amount paid to the insurer does not change until the scheduled end of the insurance period.
Depreciation. The amount of depreciation associated with a fixed asset is set in accordance with the depreciation method used, and is rarely altered until the end of the asset’s useful life.
Property taxes. Property taxes are usually updated once a year or less frequently, depending on when the taxing authority elects to update its property tax database.
Allocation of Fixed Costs
Fixed costs are allocated under the accrual basis of cost accounting. Under this arrangement, fixed manufacturing overhead costs are proportionally assigned to the units produced in a reporting period, and so are recorded as assets. Once the units are sold, the costs are charged to the cost of goods sold. Thus, there can be a delay in the recognition of those fixed costs that are allocated to inventory. This delay can last for many months, depending on how slowly the related units are selling.
Fixed Cost FAQs
Are fixed costs always completely fixed?
Fixed costs are not always completely fixed. Some are step-fixed costs, meaning they remain constant within a certain level of activity but increase once capacity is expanded, such as adding a new factory or hiring another manager. Over the long term, even fixed costs like rent or salaries can change due to inflation, renegotiation, or strategic decisions.
What is the impact of fixed costs on sales?
Fixed costs do not change directly with sales volume, but they affect the sales level needed to break even. Higher fixed costs require more sales to cover those costs before profit begins. Once fixed costs are covered, additional sales can increase profit rapidly if contribution margins remain positive.