What is fixed cost?
A fixed cost is a business expense that does not fluctuate due to factors like production volume or sales figures. As its name suggests, this is a cost that remains a constant in a company’s financial balance, such as warehouse rent or a monthly internet bill for company office buildings.
Fixed costs versus variable costs
Fixed costs remain largely the same from one accounting period to the next. That’s not to say if the price of your company’s phone bill is ten dollars off a month from what it was five years ago, it can no longer be counted as a fixed cost. However, it’s the principle of a steady, recurring expense that makes an accountant treat a line item as a fixed cost.
On the other hand, variable costs depend on factors that are subject to change, namely elements within the production and sales processes. An example of variable cost might be the price paid for raw materials, or the number of salespeople hired to market the launch of a new product. These are expenditures that could appear one accounting period, and totally disappear (or double!) by the next. So they are important to factor into your bookkeeping processes.
Together, fixed costs and variable costs make up a company’s total costs. That number is important for company accounting purposes.
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Relationship between fixed costs and profit
Tracking fixed costs is useful for assessing the financial stability of your company and setting goals for future quarters. Namely, knowing your fixed costs helps you determine your break-even point. That’s the moment at which the production cost (the cost it took a company to make an item, which includes both fixed and variable costs) equals the revenue (the money recouped from that same item).
To calculate your break-even point, divide your fixed costs by the difference between an item’s sales price and its variable costs. The result will tell you the number of units you have to produce to “break even.”
Some companies naturally require high fixed costs. Perhaps you own a manufacturing business, and the cost of renting a massive factory complex is extremely expensive. Yet, if the cost to make each individual item is quite low (i.e. low variable costs), it’s easy to make a large profit after surpassing your break-even point.
Other companies are the inverse. Freelancers or consultants who work from home are good examples of businesses with low fixed costs, as they save on rent, salaries, and office equipment. However, the cost of doing a project doesn’t change even after you reach the break-even point, so there won’t be a major difference in profit growth. Instead, your profit growth will remain quite steady.
Either way, understanding your fixed costs will let you better assess the ways in which you can expect your profits to develop as you start your business and as it grows.