Fixed costs are business expenses that remain the same each month, no matter how many goods the company produces or services it delivers. These costs stay the same whether revenues increase or decrease.
This article will help you understand what fixed costs are, how to identify them, and why they're important to your business.
What Is Fixed Cost?
Your business is likely responsible for paying fixed costs even if you don't make a single sale or produce a single product.
Fixed costs are the opposite of variable costs, which fluctuate depending on how many goods your business produces or how many services you provide.
Fixed costs combined with variable costs make up your business's total costs.
Examples of Fixed Costs
Every business has fixed costs, but the type of fixed costs your business pays depends on the type of goods or services you produce.
Some common examples of fixed costs include:
- Advertising. This may include the cost of website hosting or media campaigns.
- Depreciation and amortization. Depreciation of equipment and other property using the straight-line method is an example of a fixed cost. Depreciation calculated using the units of production method would be an example of a variable cost.
- Insurance. Monthly or annual premiums paid for business insurance are generally a fixed cost.
- Interest expense. Interest paid on a fixed-rate loan is a fixed cost.
- Rent or mortgage payments. Monthly payments to a property owner or mortgage lender are generally fixed costs.
- Salaries. Salaries that aren't dependent on the number of hours an employee works are fixed costs. Other types of compensation, such as hourly wages and commissions, are variable expenses.
- Utilities. The cost of some utilities, such as electricity and water, may go up when production increases. However, utilities are generally considered fixed costs because you must pay a minimum amount regardless of your sales or production volume.
How to Identify Fixed Costs
To find your business's fixed costs, review your budget or profit and loss statement. Look for expenses that don't change from month to month, regardless of the number of goods you produce or services you sell. Any costs that remain constant—even if you produce and sell nothing—are fixed costs.
Add up all those costs to find your company's total fixed costs.
Why Are Fixed Costs Important?
Knowing your total fixed costs is important because it can help you price your products or services and ensure your business is profitable.
The first step is to calculate your average fixed costs, which gives you an idea of how much it costs to produce your product or service before accounting for variable costs. You calculate average fixed costs using the following formula:
Average Fixed Costs = Total Fixed Costs ÷ Number of Units Produced
For example, say you manufacture hairbrushes, and your monthly fixed costs are as follows:
Total fixed costs
Currently, you produce 12,000 hairbrushes per month, so your average fixed costs are:
$11,350 ÷ 12,000 = $0.95
So, for every hairbrush you produce, $0.95 goes to cover fixed costs. If you slow down production and produce fewer hairbrushes each month, your average fixed costs will increase. If you increase production, your average fixed costs will go down.
Knowing your fixed costs can also help you calculate your break-even point. This is the number of units you need to sell to make your business profitable.
Break-even point = Fixed costs ÷ (Price – Variable costs per unit)
Returning to your hairbrush manufacturing business, let's say your variable costs are $5 per brush, including the materials, labor, and supplies used in the manufacturing process. You decide to sell your hairbrushes for $15 each.
So, how many brushes will you need to sell per month to be profitable? You can plug those numbers into the formula.
$11,350 fixed costs ÷ ($15 per brush - $5 variable costs) = 1,135 hairbrushes
You need to sell 1,135 hairbrushes every month to break even, and any brushes sold beyond that break-even point will generate profits for your business.
Calculating fixed and variable costs might not be your favorite part of running a business. However, keeping a close eye on these numbers gives you a clearer picture of your business operations and it helps you make better decisions about your expenses and the impact they have on your profitability.