What Is a Fixed Cost?
A fixed cost is a business expense that does not change with short‑term changes in production or sales volume within a defined relevant range. Fixed costs are typically contractual or scheduled expenses such as rent, insurance, interest, property taxes, depreciation and many management salaries. They are the baseline costs that a company must cover regardless of output.
Key takeaways
– Fixed costs remain constant in total across a relevant range of activity; per‑unit fixed cost falls as output rises.
– Fixed costs contrast with variable costs, which change in direct proportion to production or sales.
– Fixed costs appear in operating expenses, depreciation schedules and sometimes in cost of goods sold (if directly tied to production).
– Fixed-cost structure affects breakeven points, operating leverage and the company’s profit sensitivity to changes in sales.
Common examples of fixed costs
– Rent and lease payments
– Property taxes and insurance premiums
– Depreciation of plant and equipment
– Interest expense on loans
– Salaries of permanent management or salaried staff
– Some utilities with minimum charges or flat fees
Fixed vs. variable costs (and semi‑variable costs)
– Variable costs change in total with production (e.g., raw materials, piece‑rate labor, sales commissions).
– Fixed costs remain constant in total over the relevant range (e.g., factory rent).
– Semi‑variable (mixed) costs contain both fixed and variable components (e.g., a phone bill with a flat monthly charge plus usage fees; repairs with a base maintenance contract plus usage‑related repairs).
How fixed costs show up on financial statements
– Income statement: recorded as operating expenses or cost of goods sold (if directly related to production, like factory depreciation).
– Balance sheet: some fixed obligations appear as current or long‑term liabilities (e.g., lease liabilities, long‑term debt).
– Cash flow statement: cash payments related to fixed costs (rent, interest) show in operating or financing cash flows; noncash fixed costs (depreciation) are added back in operating cash flow.
Are all fixed costs sunk costs?
No. Fixed costs and sunk costs are related but not identical:
– A sunk cost is a cost already incurred and unrecoverable; it should not affect forward-looking decisions.
– Some fixed costs are sunk (past depreciation already recorded), but many fixed costs are future obligations that can be altered (e.g., lease can be renegotiated, a salaried position can be eliminated). Treat only irrecoverable costs as sunk.
Why fixed costs matter
– Breakeven analysis: higher fixed costs raise the number of units needed to break even.
– Economies of scale: as output rises, fixed costs per unit fall, improving margin if demand exists.
– Operating leverage: companies with higher fixed-cost proportions experience larger swings in profit for a given change in sales.
Breakeven analysis — formula and example
Breakeven units = Fixed Costs / (Sales price per unit − Variable cost per unit)
Example:
– Fixed costs (F) = $200,000
– Price per unit (P) = $50
– Variable cost per unit (V) = $30
Contribution margin per unit = P − V = $20
Breakeven units = 200,000 / 20 = 10,000 units
This is the number of units that must be sold for revenue to exactly cover both fixed and variable costs (zero operating profit).
Operating leverage — formula and example
Degree of operating leverage (DOL) at a quantity Q can be computed as:
DOL = [Q × (P − V)] / {[Q × (P − V)] − F}
Example using the numbers above and Q = 15,000 units:
– Contribution = 15,000 × $20 = $300,000
– Operating income = Contribution − Fixed costs = 300,000 − 200,000 = $100,000
DOL = 300,000 / 100,000 = 3
Interpretation: at this output level, a 1% increase in sales (volume or revenue, depending on definition) would produce approximately a 3% increase in operating income.
Special considerations
– Relevant range: fixed costs are constant only within a certain activity range; stepping beyond it often triggers changes (new facilities, renegotiated leases).
– Allocation to COGS: some fixed costs (e.g., factory rent, equipment depreciation) are allocated to cost of goods sold; allocation methods affect gross margin and operating margin.
– Timing and cash vs. noncash: depreciation is a noncash fixed expense; interest and rent are cash fixed expenses affecting liquidity.
Practical steps for managers (how to identify, analyze and act on fixed costs)
1. Identify and classify costs
– List all recurring expenses and classify as fixed, variable or mixed within the relevant range.
– Confirm which fixed costs are tied directly to production (allocated to COGS) and which are period operating expenses.
2. Build a cost model
– Create a simple model with P, V, F and Q so you can compute contribution margin, breakeven units, operating income and DOL.
– Use the model to run scenarios (e.g., price changes, variable cost reductions).
3. Perform breakeven and sensitivity analyses
– Compute breakeven units and breakeven revenue.
– Run sensitivity tests: how many units lost/gained to change operating income by X%? What if variable costs increase by Y%?
4. Monitor key metrics and ratios regularly
– Contribution margin per unit, contribution margin ratio = (P − V) / P
– Fixed cost ratio = Fixed costs / Total costs (or as share of operating costs)
– Degree of operating leverage
– Breakeven in units and dollars
5. Reduce or better manage fixed costs where feasible
– Renegotiate leases, outsource noncore functions to convert fixed costs into variable fees, adopt pay‑for‑performance for some salaries, consider leasing vs buying equipment to shift cash flow profile.
– Evaluate automation: it often raises fixed costs but lowers variable cost per unit — check demand forecasts and breakeven effects.
6. Use scenario planning for capacity shifts
– For planned expansions or contractions, include step‑costs (when fixed costs rise in steps as capacity increases).
– Consider long‑term contracts and flexibility clauses to limit exposure.
7. Communicate and govern
– Ensure finance, operations and procurement coordinate on decisions that change fixed commitments.
– Set review cadences for large fixed commitments (e.g., quarterly for leases, annually for headcount planning).
Common KPIs and ratios to track
– Breakeven units and breakeven dollars
– Contribution margin per unit and contribution margin ratio
– Fixed cost coverage: (Contribution) − Fixed costs = Operating income
– Degree of operating leverage (DOL)
– Fixed costs as % of total operating costs
Practical example checklist for running a quick analysis
– Step 1: List fixed costs and total amount F.
– Step 2: Determine average price per unit P and variable cost per unit V.
– Step 3: Calculate contribution margin per unit (P − V).
– Step 4: Compute breakeven units = F / (P − V).
– Step 5: Choose planned production Q and compute operating income = Q × (P − V) − F.
– Step 6: Compute DOL = [Q × (P − V)] / ([Q × (P − V)] − F) and run ±10% sales sensitivity to see profit impact.
– Step 7: Review fixed costs for conversion opportunities and renegotiation.
Tips
– Always define the relevant range before labeling a cost “fixed.”
– When demand is uncertain, prefer more variable-cost structures to reduce downside risk; when demand is predictable and high, higher fixed costs can amplify profits.
– Distinguish cash fixed costs (impact liquidity) from noncash fixed costs (depreciation, amortization) when planning cash flow.
The bottom line
Fixed costs are foundational to a firm’s cost structure and influence unit economics, breakeven, profitability sensitivity and strategic decisions about scale and flexibility. Managers should identify, monitor and model fixed costs, and use targeted actions (renegotiation, outsourcing, contract design) to align their fixed/variable mix with demand risk and strategic goals.
Source
Adapted and summarized from Investopedia — “Fixed Cost” (https://www.investopedia.com/terms/f/fixedcost.asp).