Expenses are the basis for calculating the cost and planning the price of goods or services. Companies traditionally categorized expenses as fixed, variable, and irregular. Fixed costs reflect expenditures that aren’t affected by sales or production levels of the company. Keep reading our article to learn more about fixed and variable costs and how to calculate fixed expenses.
Understanding Fixed Cost
A fixed cost (FC) is one that doesn’t change during operating a business when producing more or fewer products. If the production increases or decreases, and the prices change, those are variable costs. A fixed cost may be business property such as equipment or a building.
For example, a company specializes in producing and bottling ice tea. This business needs at least one line to create the tea and one line to bottle ice tea. It also needs a building to set equipment.
This means that the company has to buy the assets or to pay for the rent of equipment and the building. Choosing rent, the owner has to conduct 100% of the monthly rent payment regardless of financial business success. The cost of paying rent won’t change whether the company produces 100.000 bottles a month, just one bottle or none.
However, fixed costs may change, but not based on a decrease or increase of production levels. Prices keep changing, and some of the reasons may include:
- The building or equipment owner decides to change the price for the next several years. It will remain fixed, but the company has to pay more than previous years.
- The company had an agreement with the owner of the building/equipment. The agreement includes a fixed schedule that states how prices will increase.
For example, the lease contract is about to expire, so the production company has to renegotiate the payment terms. In the last three years, the company paid $9,000 in rent per month, but according to the new contract, the payment increased, and now the business agrees to pay $10,000 per month.
Examples of a Fixed Cost
As mentioned, a typical example of a fixed expense is rent. But accounting also recognizes utility bills, employees’ salaries, wages as fixed costs. Here are some other examples of fixed costs for you to understand the topic better:
- Vehicle leases. If your business leases cars, these come with fixed monthly payments during the entire lease period.
- Insurance. Insurance expenses like property insurance or healthcare for employees should remain unchanged throughout the duration of the policy.
- Property rent. You get the same check for rent every month. The only two exceptions are if you change places or the landlord increases the price based on factors other than production or sales level increase.
- Property taxes. If a business owns assets like buildings, equipment, machinery, vehicles, then the taxes a business pays remain unchanged.
- Depreciation. It is the process of transferring the cost of fixed assets to the finished product. The equipment sooner or later becomes obsolete and loses its usefulness gradually.
- Utility bills. Typically, such expenses as telephone and Internet bills, website hosting, electricity barely fluctuate during the entire year. But in some cases, utilities may be classified as variable expenses depending on the type of work a business performs.
- Payroll. The money that the company pays each month to administrative staff or other employees, except workers receiving performance-related wages.
- Permits and licenses. If a company relies on licenses and permits to provide services or goods, then it needs to pay a fixed price every specific period.
- Interest on loans. It should remain unchanged unless a business pulls out more loans or manages to make a significant payment to reduce current loans.
These are the most common examples of fixed costs. Fixed costs have to be added to the indirect expense section of the income statement that leads to operating profit.
Keeping proper financial records is time-intensive and small mistakes can be costly. BooksTime makes sure your numbers are 100% accurate so you can focus on growing your business.
Fixed Costs vs. Variable Costs
Variable costs (VC) are those expenses that fluctuate depending on the production level. For instance, if the total number of produced goods increases, variable expenses also increase. If the production level decreases, then so do the costs.
Fixed expenses will remain unaffected by the company’s progress or lack of it. But variables are directly affected by the business’s output. This is the major difference between these two types of expenses. Take a look at variable costs:
- direct labor;
- commissions and fees;
- operational expenditure.
It’s clear that these costs change depending on the company’s production volume. Therefore, the production should achieve economies of scale to reduce the cost-share in the price.
How to Calculate Fixed Costs
It’s relatively easy to calculate fixed costs even if you are new to this process. One of the simplest methods is to calculate all fixed expenses then add them up to get a total. It’s also possible to use a formula to calculate fixed expenses.
Let us first see the formula:
- Total volume of production costs — (Variable cost per unit * Number of units produced) = Fixed costs (FC)
It’s clear from the formula that we need to add up all production costs. The next step is to calculate the variable cost per unit and multiply it by all units produced. When you get this second number, subtract it from total production costs. That way, you get a total fixed cost.
When calculating total fixed costs, make sure to differentiate between variable and fixed costs to avoid any mistakes in your calculations.
Author: Charles Lutwidge