A fixed cost is a cost that does not vary in the short term, irrespective of changes in production or sales levels, or other measures of activity. A fixed cost is a basic operating expense of a business that cannot be avoided, such as a rent payment. The concept is used in financial analysis to find the breakeven point of a business, as well as to determine product pricing.
To continue the example of a fixed cost, the rent on a building will not change until the lease runs out or is re-negotiated, irrespective of the level of business activity within that building. Examples of other fixed costs are insurance, depreciation, and property taxes. Fixed costs tend to be incurred on a regular basis, and so are considered to be period costs. The amount charged to expense tends to change little from period to period.
When a company has a large fixed cost component, it must generate a significant amount of sales volume in order to have sufficient contribution margin to offset the fixed cost. Once that sales level has been reached, however, this type of business generally has a relatively low variable cost per unit, and so can generate outsized profits above the breakeven level. An example of this situation is an oil refinery, which has massive fixed costs related to its refining capability. If the cost of a barrel of oil drops below a certain amount, the refinery loses money. However, the refinery can be wildly profitable if the price of oil increases beyond a certain amount.
Conversely, if a company has low fixed costs, it probably has a high variable cost per unit. In this case, a business can earn a profit at very low volume levels, but does not earn outsized profits as sales increase. For example, a consulting business has few fixed costs, while most of its labor costs are variable.
Fixed costs are allocated under the absorption 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.