Fixed overhead is a set of costs that do not vary as a result of changes in activity. These costs are needed in order to operate a business. One should always be aware of the total amount of fixed overhead costs that a business incurs, so that management can plan to generate a sufficient amount of contribution margin from the sale of products and services to at least offset the amount of fixed overhead. Otherwise, it is impossible to generate a profit.
Since fixed overhead costs do not change substantially, they are easy to predict, and so should rarely vary from the budgeted amount. These costs also rarely vary from period to period, unless a change is caused by a contractual modification that alters the cost. For example, building rent remains the same until a scheduled rent increase alters it. Alternatively, the recognized impairment of a fixed asset may reduce the amount of depreciation expense associated with that asset.
Examples of fixed overhead costs that can be found throughout a business are:
- Office expenses
- Administrative salaries
- Depreciation and amortization
Examples of fixed overhead costs that are specific to a production area (and which are usually allocated to manufactured goods) are:
- Factory rent
- Production supervisory salaries
- Normal scrap
- Materials management staff compensation
- Quality assurance staff compensation
- Depreciation on production equipment
- Insurance on production equipment, facilities, and inventory
Fixed overhead costs are allocated to products using the following steps:
- Assign all expenses incurred in the period that are related to factory fixed overhead to a cost pool.
- Derive a basis of allocation for applying the overhead to products, such as the number of direct labor hours incurred per product, or the number of machine hours used.
- Divide the total in the cost pool by the total units of the basis of allocation used in the period. For example, if the fixed overhead cost pool was $100,000 and 1,000 hours of machine time were used in the period, then the fixed overhead to apply to a product for each hour of machine time used is $100.
- Apply the overhead in the cost pool to products at the standard allocation rate. Ideally, this means that some of the allocated overhead is charged to the cost of goods sold (for goods produced and sold within the period) and some is recorded in the inventory (asset) account (for goods produced and not sold within the period).
Fixed overhead costs can change if the activity level varies substantially outside of its normal range. For example, if a company needs to add onto its existing production facility in order to meet a large increase in demand, this will result in a higher rent expense, which is normally considered part of fixed overhead. Thus, fixed overhead costs do not vary within a company's normal operating range, but can change outside of that range. When such a change occurs, it is known as a step cost.
If fixed overhead is allocated to a cost object (such as a product), the allocated amount is considered to be fixed overhead absorbed.
The other type of overhead is variable overhead, which varies in proportion to changes in activity. The amount of fixed overhead is usually substantially greater than the amount of variable overhead.
Fixed manufacturing overhead or factory overhead is a subset of fixed overhead, because it only includes those fixed overhead costs incurred in the manufacturing process.