Fixed Asset

Understanding fixed costs

A fixed cost is an expense that a business incurs regardless of how much it produces or sells. These are regular expenses like rent, interest payments, and insurance that don't directly relate to production, often referred to as "fixed costs." Because they are not tied to the level of production, fixed costs are usually considered indirect costs. Businesses often look for ways to reduce fixed costs to improve profitability.

What are fixed costs?

Fixed costs are expenses that stay constant over time. They are typically established through schedules or business agreements and are essential for running a business. Once set, these costs don't change throughout the contract or cost schedule period.

Examples of fixed costs:

  • Depreciation: Spreading out the cost of tangible assets like equipment over their useful life.
  • Rent: Regular payments for using a landlord’s property.
  • Salaries: Fixed wages paid to employees, regardless of hours worked.
  • Insurance: Regular payments according to an insurance policy.
  • Interest Expense: The cost of borrowing money, fixed if the loan has a fixed interest rate.
  • Property Taxes: Taxes imposed by local government based on the value of company assets.
  • Utilities: Costs like gas, electricity, and telephone services. While there is a variable component, the overall expense tends to be fixed.

Learn more about Inkle Intracompany. 

Fixed vs. variable costs

Fixed Costs: These do not change with the level of production. They are included in the indirect expense section of the income statement and can impact operating profit.

Variable Costs: These change directly with the level of production. For example, raw materials and shipping costs can fluctuate based on how much is produced or sold.

How fixed costs impact business?

Allocation in financial statements: Fixed costs are showcased in the indirect expense palce of the income statement, contributing to operating profit. Depreciation is a common example of a fixed, indirect expense.

Economies of scale: Businesses producing large quantities can benefit from economies of scale, where fixed costs per unit decrease as production increases. This can help improve overall profitability.

Consistency principle: Under US generally accepted accounting standards (GAAP), businesses must consistently use the same accounting method from one period to the next. If a company changes its method, it must disclose this in the financial statements' footnotes and apply the new method retroactively.

Let's take the example of a small coffee shop, "Brewed Awakening."

Fixed costs:

  • Rent: $2,000 per month
  • Salaries: $3,000 per month (for full-time staff)
  • Utilities: $500 per month
  • Insurance: $200 per month

Total fixed costs: $5,700 per month

Scenario:

In a typical month, Brewed Awakening sells 10,000 cups of coffee at an average price of $3 per cup, generating $30,000 in revenue.

Impact of fixed costs:

  1. Break-Even Point:some text
    • To cover the fixed costs of $5,700, the coffee shop needs to sell enough cups to reach this amount. If each cup generates $3 in revenue, the break-even sales volume is $5,700 / $3 = 1,900 cups.
    • This means Brewed Awakening must sell at least 1,900 cups of coffee each month just to cover its fixed costs, without considering variable costs like coffee beans, milk, and cups.
  2. Profitability:some text
    • After covering fixed costs, additional sales contribute to profit. If the shop sells 10,000 cups, it generates $30,000.
    • Subtracting the fixed costs ($5,700) and variable costs (let's assume $1 per cup, totaling $10,000), the profit is $30,000 - $5,700 - $10,000 = $14,300.
  3. Scaling Impact:some text
    • Fixed costs remain constant regardless of the number of cups sold. This means as sales volume increases, the fixed cost per unit decreases, improving profit margins.
    • For example, if sales double to 20,000 cups, the fixed cost per cup becomes $5,700 / 20,000 = $0.285, significantly lower than the original $0.57 per cup when selling 10,000 cups.

Fixed costs have a significant impact on a business's break-even point and profitability. For Brewed Awakening, managing fixed costs effectively ensures they cover their expenses and maximise profits as sales increase. Understanding and controlling these costs can be crucial for the long-term sustainability and growth of the business.

Read further: What are payroll taxes?

In summary

  • Fixed Costs: These are costs a company incurs, regardless of production levels, established for a set period.
  • Impact on Profitability: Fixed costs can affect profitability at various stages of the income statement and can be either direct or indirect.
  • Examples include rent, salaries, insurance, interest expense, and depreciation.

Fixed costs are a crucial part of a business’s overall cost structure and play a significant role in financial planning and analysis.

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