Fixed costs are expenses that remain constant within a certain range of production or sales volume over a specific period. These costs do not vary with the level of production or business activity and remain stable regardless of changes in output.
What are fixed costs?
Fixed costs are associated with the basic operation and existence of a business, and they must be paid even if production or sales decrease.
Common examples of fixed costs include rent or lease payments for facilities, salaries of permanent staff, insurance premiums, property taxes, and certain administrative expenses. These costs do not vary with the number of units produced or sold.
Fixed costs are typically considered within a specific time horizon, such as a month, quarter, or year. Over shorter periods, some costs that appear fixed, like rent, may be subject to change in the longer term.
Understanding the fixed cost component of the overall cost structure is important for businesses. It helps in determining the break-even point—the level of production or sales at which total revenue equals total costs, including both fixed and variable costs.
Since fixed costs remain constant, changes in production levels can impact the profitability of a business. As production increases, fixed costs are spread over a larger number of units, reducing the fixed cost per unit and potentially improving profit margins.
Many fixed costs involve long-term commitments, such as leasing agreements or salaries for permanent employees. Businesses must carefully evaluate these commitments and consider the implications on their financial stability.
Example of fixed costs
Let’s consider Company XYZ, a software development company. The following are examples of fixed costs for Company XYZ:
- Rent: £5,000 per month – The monthly cost of leasing office space, which remains constant regardless of the number of software projects developed.
- Salaries of administrative staff: £10,000 per month – The salaries of administrative personnel who handle general office tasks and support functions.
- Insurance premiums: £2,000 per month – The monthly cost of business insurance coverage, which remains constant regardless of the level of software development activities.
- Depreciation of office equipment: £3,000 per month – The allocated cost of depreciating office equipment, such as computers and furniture, which is a fixed expense over the short term.
The total fixed costs for Company XYZ amount to £20,000 per month. Even if the company produces more or fewer software projects, these fixed costs remain constant.