Managing a company’s cost structure involves a lot of planning. Each business has a range of associated costs that may be fixed or variable. These costs can be direct, indirect, capital, profit-based, and varied, depending on the area and scale of the business.
Since the figures are expected to change periodically, solid planning is needed to ensure the budget constraints of the company are addressed expertly. Typically, the cost structure includes long-term and short-term liabilities, which are classified under fixed and variable costs.
The management of this cost structure is a crucial aspect of business analysis as it ensures the company can sail smoothly if there is a dip in revenue or a need for extra expenses. Thus, cost analysis affects the profitability of a business and should be handled seriously.
While certain costs are flexible in nature, several fixed costs should be allocated in advance on financial statements. Here, we will guide you on what a fixed cost can be, how to allocate one, a few examples, and the fixed cost formula.
Fixed costs, also known as overhead costs, are the fixed expenses in a business that do not change over a period of time. These costs are independent of factors like sales, production volume, number of employees, etc.
At least in the short term, fixed costs can be considered set expenses. Depending on the industry, fixed costs can be high or low.
For instance, factories or businesses working with heavy machinery might have higher fixed costs in maintenance, repair, and storage space. On the other hand, an online store may have low fixed costs and higher variable costs, based on their products and demand.
It is essential to accurately track fixed costs as they have to be paid out of whatever revenue you make. Hence, you must have a plan to cover these costs - even if sales are low for a period of time.
Here's a rundown of some key features of fixed costs:
- Fixed costs are business expenses that do not depend on the level of goods or services.
- These are recurring costs and must be paid every month or quarter, as applicable.
- They can be negotiated for a specific time period and do not change with production levels.
- These costs can decrease on a per unit basis if they are based on the direct cost portion of the company’s income statement.
- Fixed costs can be established by contract agreements or schedules and do not change over the life of the agreement.
What is meant by net income? Best answers are given to you by our very experts, to help you with what is net income.
Although they vary from business to business, certain examples of fixed costs are common across the board. Some of them include:
- Rent or Lease Payments: For businesses working in rented or leased spaces.
- Employee Salaries: Should be a fixed compensation cost over a period of time for individual employees.
- Insurance and Taxes: Includes property taxes to local governments and insurance premiums.
- Advertising: Includes marketing campaigns, website hosting, media strategies, etc.
- Depreciation and Amortization: Include writing off the costs of tangible and intangible assets gradually over their life period
- Interest Expenses: Includes interests to be paid on loans and borrowed assets
- Utilities: Basic operating expenses examples like gas, phone bills, internet charges, electricity, trash and sewer services, and so on. Since some of these charges can be variable, the company holds a minimum amount as a fixed cost.
Each business has a different combination of fixed costs, depending on where they are working from, how many employees and contractors are involved, the type of product or service they provide, etc.
Thus, calculating the fixed cost can be tricky. The simplest thing is to perform a cost analysis of your business and determine from your budget or income statement which expenses do not change over time.
These figures would have to remain constant even if the output quantity fluctuates and the business activity resorts to zero. This calculation comes with two easy steps.
- Review all company expenses through financial statements and make a comprehensive analysis of which costs do not change monthly.
- Add up all these costs to get the total fixed cost of your company.
After determining the total cost, there is a simple formula to calculate the average fixed cost for a specific time period.
The average fixed cost in a company is the fixed cost per unit. It is calculated by dividing the fixed production cost by the quantity of output produced.
This number aims to give you an idea of the fixed cost involved in making a product or providing your service before variable costs are included.
The average fixed cost formula is as follows:
Average Fixed Cost = Total Fixed Cost / Number of Units Produced
Let's look at an example.
A company, Trident Productions, makes toys for kids. They want to find out their average fixed costs by listing their total monthly fixed costs.
Trident Productions makes 12,000 toys per month. Applying the average fixed cost formula here, the calculation would be:
17,900 / 12,000 = $1.49
Hence, for each toy, the average fixed cost of this company would be $1.49.
If Trident increases production without causing any difference in the fixed costs, their average fixed cost will decrease. On the other hand, this amount will increase if they produce fewer toys every month.
Apart from fixed costs, a company’s expenses go into variable costs like raw materials, labor hours, shipping and delivery, etc. If business owners can decrease these costs, their profit margin will increase.
However, if your business type is such that it suffers by decreasing variable costs, the only suitable thing to do is to cut down on your fixed costs to increase profits.
For instance, a garment manufacturer might find the quality of products compromised if they decrease raw material or tailoring costs.
For such businesses, the fixed cost can be lowered through certain aspects.
- Decrease rent by working from a reasonable space or opting for a lower lease.
- Share your workspace with other businesses to decrease costs.
- Reduce the number of salaried employees as far as possible, without creating massive pressure on the remaining ones.
- Consider multiple options before choosing the most suitable insurance deal for your company.
- Reduce debts on the company and pay off pending loans.
- Focus on organic marketing to reduce advertising costs.
Fixed costs set a minimum expense limit for the company and ensure smooth operations can be maintained even in tough times. Keeping these costs on track will help make better financial decisions and ensure the optimal profitability of your business.
If you run a small creative business and need help crunching numbers to calculate fixed costs, consider reaching out to a professional bookkeeping service like Fincent.