When you make a business budget or review your company’s expenses, those expenses are usually classified as either fixed costs or variable costs. While both are important, getting a clear picture of your business’ fixed costs is crucial. Why? Because you need enough cash on hand to cover fixed costs, even if you don’t have any sales.
What is fixed cost?
Fixed costs, sometimes referred to as overhead costs, are expenses that don’t change from month to month, regardless of the business’ sales or production volume. In other words, they are set expenses the company must pay, at least in the short term.
Some businesses have high fixed costs. For example, manufacturers tend to have high fixed costs because they need equipment and space for their operations, even if they haven’t sold a single product.
On the other hand, some businesses have low fixed costs and higher variable costs. For example, a mobile dog groomer might have few fixed expenses in between jobs but have higher variable costs (such as mileage, shampoo, dog treats, and accessories).
Knowing your fixed costs is essential because you typically don’t know for sure how much revenue you will earn each month. But if you know your fixed costs, you know how much you need to make each month to keep the lights on. You can also plan for a slow period of time by building cash reserves or setting up a line of credit.
Examples of fixed cost
Common fixed expenses include:
- Depreciation and amortization – the gradual writing off of the cost of tangible and intangible assets over their useful lives
- Advertising – including the cost of website hosting and media campaigns
- Salaries– fixed compensation amounts paid to employees regardless of the number of hours worked
- Rent or mortgage payments – monthly payments to a landlord or lender
- Insurance – periodic premiums paid to an insurance company
- Interest expense – the cost of borrowing, as long as the loan agreement calls for a fixed rate of interest
- Property taxes – taxes charged by a local government
- Utilities– the cost of electricity, gas, phones, trash and sewer services, etc. Some utilities, such as electricity, may increase when production goes up. However, utilities are generally considered fixed costs, since the company must pay a minimum amount regardless of its output.
How to find fixed costs
Your business’ fixed cost accounting will be different from other companies, depending on whether you rent or own, hire employees or independent contractors, manufacture products or deliver a service, etc.
To find your company’s fixed costs, review your budget or income statement. Look for expenses that don’t change, regardless of your business’ quantity of output. Any costs that would remain constant, even if have zero business activity, are fixed costs.
How to calculate fixed cost
To determine your business’ total fixed costs:
Review your budget or financial statements. Identify all the expense categories that don’t change from month to month, such as rent, salaries, insurance premiums, depreciation charges, etc.
Add up each of these fixed costs. The result is your company’s total fixed costs.
Once you know your total cost, you can use that number to calculate average fixed cost.
What is average fixed cost?
Calculating your company’s average fixed cost tells you your fixed cost per unit, which gives you a sense of how much it costs to produce your product or service before factoring in variable costs.
Total Fixed Cost / Number of Units Made = Average Fixed Cost
To illustrate, say Pucci’s Pet Products manufactures dog collars and wants to know its average fixed cost per collar. Pucci’s monthly fixed costs are as follows:
|Depreciation on equipment||$500|
|Total fixed costs||$14,750|
Currently, Pucci’s produces 10,000 dog collars per month. So Pucci’s average fixed cost would be as follows:
$14,750 / 10,000 = $1.47
So for every dog collar Pucci’s Pet Products produces, $1.47 goes to cover fixed costs. If Pucci’s slows down production to produce fewer collars each month, it’s average fixed costs will go up. If Pucci’s can increase production without affecting fixed costs, its average fixed cost per unit will go down.
Variable vs. fixed costs
When business owners want to increase profits and make more money per sale, they often look at lowering their cost of goods sold, including variable costs. Examples of variable costs include the costs of raw materials and labor that go into each unit of product or service sold.
It makes sense. After all, if a company can reduce the cost of materials and labor, profits increase. However, many companies find that they can only lower their variable costs so much before quality begins to suffer, and they lose business.
If you’re interested in cutting costs but can’t cut back on materials and labor without sacrificing quality, it’s time to look for ways to reduce fixed costs.
Here are some common ways to reduce fixed costs for your business:
- Relocate to an area with cheaper rent or negotiate lower lease payments with your landlord
- Sub-lease a portion of your space to another tenant who will pay rent
- Reduce the number of salaried employees on staff
- Shop around for lower insurance premiums
- Refinance or pay off debt to reduce or eliminate interest payments
Both fixed costs and variable costs help provide a clear picture of your business’ operations. Understanding the difference between the two can help you make better decisions about your cash flow, expenses, and the impact they have on profitability.