Fixed Costs What it is: Fixed costs are costs that do not change when the quantity of output changes. Unlike variable costswhich change with the amount of output, fixed costs are not zero when production is zero.
Common examples include rent, insurancesalaries and interest. There is a difference between the cost accounting definition and the financial accounting definition.
While variable costs change depending on things like sales volumes, fixed costs tend to stay the same regardless of how much or how little business a company does. For example, if a bicycle business had total fixed costs of $1, and only produced one bike, then the full $1, in fixed costs must be applied to that bike. On the other hand, if the same business produced 10 bikes, then the fixed costs per unit decline to $ Variable costs behave differently. Some business call only those expenses that remain constant throughout the year — rent, loan payments, insurance premiums, website hosting and lease payments, for example — fixed expenses.
In cost accounting, fixed costs are offset by the contribution margin. In financial accounting, the gross margin is used to cover fixed costs.
Explanation of Fixed Costs In accounting we use the break even point formula to establish some form of minimum production or sales to cover costs. Some of these costs are fixed in nature due to the underlying need or compliance for the item.
I sighted rent above, but other types of costs that are required include electricity, insurance, interest on debt and more. The key to understanding fixed costs is to think of what would I have to pay if nobody showed up to work this month or I did not sell a single widget, in effect I did nothing to earn money?
You can see how rent qualifies; the landlord is going to require payment due to contractual obligation. Your bank will want its note payment; regardless of your production.
The insurance company has to be paid as a legal requirement for you to be in business.
Property taxes do not take vacations. These are fixed costs. Each industry is going to have different forms or types of fixed costs. In some industries, salaries are paid even if no work is accomplished.
Think of the hospital, it still needs doctors and nurses even if no patients show up at the emergency room.
In some small businesses, the staff is salaried. So even though you may not sell any product, they still have to be paid. The underlying principle of a fixed cost is the expense requires payment no matter what happens. This is where the break even point comes into play.
The idea is that every product or service provided has some form of a variable and fixed cost. A good example is the fast food restaurant.
Prior to the patron walking in to order lunch, the staff is in place, the fryer is heated up, the grill is ready, the lights are on and the restaurant is ready to serve.
You need to sell a lot of food to cover all those fixed costs that day. This example is used in cost accounting to define contribution margin. In effect it states: Sales less variable costs equals contribution margin.For example, if a bicycle business had total fixed costs of $1, and only produced one bike, then the full $1, in fixed costs must be applied to that bike.
On the other hand, if the same business produced 10 bikes, then the fixed costs per unit decline to $ Variable costs behave differently. A good example of a fixed cost is rent. If a company rents a warehouse, it must pay rent for the warehouse whether it is full of inventory or completely vacant.
Other examples of fixed costs include executives’ salaries, interest expenses, depreciation, and insurance expenses. If you need to start cutting back on costs, look at both your fixed and variable expenses.
Devoting a Saturday afternoon to reviewing all of your subscriptions, insurance plans, and recurring monthly bills may help you trim hundreds of dollars from your fixed monthly budget. Some business call only those expenses that remain constant throughout the year — rent, loan payments, insurance premiums, website hosting and lease payments, for example — fixed expenses.
You must constantly monitor expenses for your business to make sure you make a profit. Some of those expenses change as you do business. For example, labor costs qualify as a variable expense; you may hire more employees when business is good, so your variable cost of labor goes up.
For example, building rent is a fixed cost that management negotiates with the landlord based on how much square footage the business needs for its operations. If management decides to rent 10, square feet manufacturing plant at $50 a square foot, the rent will be $50, a month regardless of how many units the factory actually produces.