Fixed Costs

Rafat Abushaban

- Finance #  O 14.9K views   اقرأ بالعربية

Summary: The basic operating expenses linked to running the business itself that cannot be avoided and should be covered by the sales of products and services (in addition to variable costs) for the business to become profitable.

The term "fixed costs" is a frequently used terms in business and accounting, especially when conducting a feasibility study for a startup or when closing the financial year.

In general, the process of producing and selling commercial products or services is costly in terms of time, raw materials, the effort required to produce products and services, as well as other costs. These costs are categorized under two main sections: fixed costs and variable costs .

fixed vs variable costs

"Fixed Costs" term is usually used to include all unavoidable costs linked to the business itself, including (but not limited to) 1:

  • Rent (Location rent value, or cost of the location if it was bought).
  • Salaries (staff salaries).
  • Taxes (Relevant taxes linked to the business operations).
  • Utilities (cost of power, water, phones, and such).

The following table shows the main elements when distinguishing between fixed and variable costs.

 Fixed costs
Variable costs
MeaningThe essential operating expenses associated with running the business itself that cannot be avoidedCosts associated with producing products and services that change depending on the quantity produced
When to considerAlways calculated as long as the business exists, regardless of production, profit or loss
Calculated according to production (increases with increase in production and decreases with production decrease)
ConstraintsTime is the main determinant, as fixed costs persist with time regardless of output
Output quantity is the main determinant of variable costs
ExampleSalaries, fixed taxes, depreciation, and rent
Raw material costs, direct costs of production

Fixed Costs Example:


T-tailors is a company that custom-makes clothes. The company has three employees who design, sew, and prepare clothes. Each of the employees is paid $ 1000 a month, in addition to the monthly rental costs of the place estimated at $ 500 and a standard tax of $ 500. The company buys $ 1,000 yarn and raw materials for a given month. The cost of the electricity that powers production equipment this month is $ 500.
Having this scenario, the we can identify the following:

Fixed monthly costsVariable monthly costs
The salaries of 3 employees each are $ 1,000
Raw materials $ 1,000
The rental costs $ 500
Power cons. is $ 500
Standard tax of $ 500
-  
Total
3000+500+500=
4000$
Total
1000+500=
1500$

We note that the fixed monthly costs are $ 4,000 while the variable costs are $ 1,500

“Fixed Costs” are essential variables to learn a business’s Balance Sheet, Contribution Margin, and Break-even point.

Costs that vary in classification according to their continuity


Fixed costs can shift and become variable costs if their continuity changes. For example, take advertising costs. We find some companies allocate specific budgets on a monthly or yearly basis for these ads. In this case, this is a fixed advertising cost. On the other hand, we find other companies that do not allocate a fixed amount, but rather conduct advertising campaigns depending on the season or when launching a new product. In such case, advertising becomes a variable cost.

Can a cost be both fixed and variable?


Sometimes, we find some costs that bear characteristics of fixed costs and variable costs together. Here, these costs can be thought of as both fixed and variable costs.

For example, when a worker is paid a monthly salary, it is considered a fixed cost. Other times an employee is paid as a percentage commission for each unit he/she sells, which would be a variable cost 3 . In contrast, when the employee is paid in the form of a monthly salary plus a commission for each unit he/she sells, then we have fixed + variable costs mixed together. Other costs such as workers' wages may sometimes be called "semi-variable costs" because they are associated with both variable and fixed costs.

Fixed costs and Balance Sheets


Understanding fixed costs is crucial for anyone who wants to formulate and understand a Balance Sheets and financial statements in general. The balance sheet is based on three main components: assets, liabilities, and equity. Under the liabilities component, we find a number of fixed and variable costs that the project incurs in order to produce products and services.

balance-sheet

Here it is important to differentiate between the different fixed costs that are included in the composition of the balance sheet, which looks like the following:

Balance Sheet example

Learn more about Variable Costs and the Balance Sheet for a better financial understanding to help launch your startup.








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