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:
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Although they vary from business to business, certain examples of fixed costs are common across the board. Some of them include:
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.
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.
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.
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