Fixed cost definition
/What is a Fixed Cost?
A fixed cost is a cost that does not increase or decrease in conjunction with any activities. It must be paid by an organization on a recurring basis, even if there is no business activity. The amount charged to expense tends to change little from period to period. Fixed costs tend to be incurred on a regular basis, and so are considered to be period costs. The concept is used in financial analysis to find the breakeven point of a business, as well as to determine product pricing.
Examples of Fixed Costs
As an 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 activity within that building. Examples of other fixed costs are salaries, insurance, depreciation, and property taxes.
Impact of Fixed Costs on Sales
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.
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Allocation of Fixed Costs
Fixed costs are allocated under the accrual 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. This delay can last for many months, depending on how slowly the related units are selling.
Is Rent a Fixed Cost?
Rent is generally considered a fixed cost, because the usual lease agreement states that a fixed amount must be paid on a periodic basis. Thus, the rent expense does not change, even if there are ongoing spikes and declines in the sales of the business paying the rent. However, rent can be a variable cost in those rare cases in which the landlord is paid a percentage of the sales or profits of a business. This situation usually arises when a tenant is in financial trouble, so the landlord alters the lease to scrape up whatever it can from the reduced sales of the tenant.