What is a Fixed Cost?

What is a Fixed Cost?

Definition

Fixed costs remain constant regardless of the level of production. Consequently, an increase in output leads to fixed costs being spread over a larger number of units leading to lower average fixed costs. Companies try to control their fixed costs so that they can improve their profitability.
 

What does fixed cost mean?

A fixed cost remains unchanged at different levels of output. Consider a factory that is located in a rented building. The rent needs to be paid every month. If the factory works at full capacity, the rent will have to be paid. Even if there is zero production, rent payments will be incurred. Hence, rent is a fixed cost.   Some other fixed costs are:
  ⇨ Salaries paid to employees who do not work on an hourly basis.

  ⇨ Payment for phone services.

  ⇨ Insurance payments.

  ⇨ Lease payments for equipment.

  Of course, it is not necessary that fixed costs will remain the same indefinitely. For example, a factory may increase production to a level that requires it to hire an additional employee. This will lead to an increase in fixed costs. Similarly, the factory may run out of space and hire an additional floor in the building in which it is located. The “fixed” rental cost would go up.

  It’s important to remember that when we talk about fixed costs, we are referring to charges that remain fixed within a specific range of production. Once that threshold is crossed, the fixed cost would go up.
 

Example of fixed cost

  Pollock Brewing Company is a craft brewery that was established in 2012. The beer that it makes has seen a surge in demand in the last two years. The company’s fixed costs stand at $8 million per year. Its yearly production capacity is 100,000 barrels.

  In view of the rise in demand, the company is considering buying additional equipment to increase its manufacturing capacity. It estimates that it can raise production to 125,000 barrels per year by increasing fixed costs to $9.5 million per year. The company is confident that it can sell 125,000 barrels per year.

  The accountant calculates the impact of fixed costs at the current capacity and at the increased capacity:

  Fixed costs at the existing capacity
  Fixed costs stand at $8 million for 100,000 barrels. The average fixed cost per barrel is $80.

  Fixed costs when capacity is increased
  Fixed costs are projected at $9.5 million for 125,000 barrels. The average fixed cost per barrel is $76.

  As the per unit fixed cost is expected to fall when additional manufacturing capacity is installed, the company decides to go ahead with its expansion plan.
 

Summary

  Companies have to keep a close watch on their fixed costs to maintain profitability. Increased production levels allow fixed costs to be spread over a higher number of units. This leads to lower average fixed costs and the possibility of increasing the company’s profits.