Costs are an inherent part of our lives, isn’t it? When buying something we check what it will cost us. Exchanging something, we see what we will receive against what we give. It is our core nature to check what benefits us.
Costs are a part of our households, daily lives and businesses. However, unlike others, the costs of businesses are accounted for, and hence they are to be understood in detail as they are an important part of any business.
In business, costs are divided into two parts.
1. Fixed Cost
2. Variable Cost
Here, we will have a look at fixed costs.
“In the short run, all costs will be fixed.
In the longer run, all costs become variable.”
Table of Contents
What is Fixed Cost?
Whenever we do any expenses, some of them are the ones that often occur, whereas some costs are such that they do not happen often. Generally, fixed costs are understood as those expenses which occur rarely. They are the ones that are not directly related to outputs, and fixed costs do not change in proportion to the production output or sales. In business, fixed costs can be understood as costs that will occur irrespective of the results.
Suppose you have an accountant for your business to whom you pay a monthly salary of, say, INR 15,000. Your sales turnover for January is INR 2 lakh, and then your sales turnover for February is INR 4 lakh. Here, whether your turnover is INR 2 lakh or INR 4 lakh, you will be paying INR 15,000 only to your accountant. Hence, that becomes a fixed cost.
In continuation of the above example, if you have a sales executive to whom you pay commission on sales that occurred through him, then such payment will be a variable cost and not a fixed cost.
Categories of Fixed Costs
While fixed costs are not highly fluctuating, they also change. Depending upon the situation, fixed costs may also vary. Also, the fixed costs may depend upon the purpose for which are being occurred, and they may be divided as follows.
1. Committed Costs – These are the costs that occur to provide and maintain facilities such as rents.
2. Policy and Managed Costs – These costs are the costs that follow the organisation’s policy, such as facilities for the staff.
3. Discretionary Costs – These are the costs that are not directly related to the business operations and may occur at the discretion of the management. Such costs include bringing in new policies, conducting research etc.
4. Step Costs – As the name suggests, step costs stay constant for a certain period, and then they increase by a fixed amount.
Examples of Fixed Cost
1. Salaries – As seen in the example above, salaries paid to employees are fixed costs.
2. Rent – If you are running a business through a rented space, you will have to pay the rent to your landlord irrespective of the sales that occurred or the profits you have made.
3. Capital Assets – Capital Assets can often be termed under the fixed cost because they are spread over a while and do not occur often.
4. Depreciation – Assets of a business are subject to depreciation and may be charged at a fixed rate on a yearly basis.
Average Fixed Costs
Fixed Costs are spread over a while, while they may occur only once. When fixed costs are divided by the sales during a given period, we find average fixed costs. Average fixed costs keep declining as sales increase.
Average Fixed Cost (AFC) can be calculated as
AFC = TFC/Quantity of Sales
Where TFC stands for Total Fixed Cost.
Note – Fixed Cost is generally not measured in cost per unit, unlike variable cost.
Application of Fixed Cost
Fixed Costs are incurred to increase the operating efficiency of the production and other business systems processes. For example, buying computers or laptops for the admin department may also be a fixed cost.
The lower the fixed cost, the more the profits can be. Having said that, fixed cost initially is always high, and as the output increases, the average fixed costs will lower, thus increasing the profits.
Also, the fixed cost can be used for various business calculations such as the Break-Even Analysis and Operating leverages, and it is also the main component of Total Cost.
While costs are generally divided into fixed and variable costs, some costs are both; fixed and variable. They can either be called ‘Semi-fixed Costs’ or ‘Semi-Variable Costs’. Such costs do change concerning the output, but the proportion is not the same.
Example – the electricity cost of a business unit.
The base rate of electricity is always fixed; however, after a specific limit, the cost of electricity is per consumption unit. Hence a portion of electricity cost is permanently fixed, while another part is variable dependent upon the units consumed.
Overall, we can say that any business must understand its fixed costs since fixed costs may be in bulk and directly affect your organisation’s balance sheet. Proper knowledge of the same can help you identify the cost structure of your organisation and bring the necessary changes to it. In generic terms, it can be said that a fixed cost incurred with an on-point view can turn out to be an investment.