A fixed cost is a cost that does not change over the short-term, even if a business experiences changes in its sales volume or other activity levels. This type of cost tends to instead be associated with a period of time, such as a rent payment in exchange for a month of occupancy, or a salary payment in exchange for two weeks of services by an employee.
It is of some importance to understand the extent and nature of the fixed costs in a business, since a high fixed-cost level requires a business to maintain a high revenue level in order to avoid generating losses.
Here are several examples of fixed costs:
- Amortization. This is the gradual charging to expense of the cost of an intangible asset (such as a purchased patent) over the useful life of the asset.
- Depreciation. This is the gradual charging to expense of the cost of a tangible asset (such as production equipment) over the useful life of the asset.
- Insurance. This is a periodic charge under an insurance contract.
- Interest expense. This is the cost of funds loaned to a business by a lender. This is only a fixed cost if a fixed interest rate was incorporated into the loan agreement.
- Property taxes. This is a tax charged to a business by the local government, which is based on the cost of its assets.
- Rent. This is a periodic charge for the use of real estate owned by a landlord.
- Salaries. This is a fixed compensation amount paid to employees, irrespective of their hours worked.
- Utilities. This is the cost of electricity, gas, phones, and so forth. This cost has a variable element, but is largely fixed.
The reverse of fixed costs are variable costs, which vary with changes in the activity level of a business. Examples of variable costs are direct materials, piece rate labor, and commissions. In the short-term, there tend to be far fewer types of variable costs than fixed costs.
A business is sometimes deliberately structured to have a higher proportion of fixed costs than variable costs, so that it generates more profit per unit produced. Of course, this concept only generates outsized profits after all fixed costs for a period have been offset by sales. For example, a software development company has a fixed cost requirement of $500,000 per month and essentially no cost per unit sold, so revenues of $400,000 per month will generate a loss of $100,000, but revenues of $600,000 will generate a profit of $100,000.
Over the long term, few costs can be considered fixed. For example, a 10-year property lease can be considered a fixed cost over a nine-year period, but is a variable cost if the decision period extends past 10 years.