Fixed Cost

Fixed Cost: Definition and Use in Business

Key takeaways
* A fixed cost is an expense that does not change with short-term variations in production or sales within a relevant range.
* Typical examples: rent, insurance, interest, depreciation, property taxes, and some salaries.
* Fixed costs affect breakeven analysis, operating leverage, and per-unit costs (economies of scale).
* Not all fixed costs are sunk costs; sunk costs are unrecoverable.

What is a fixed cost?

A fixed cost is a business expense that remains constant over a specified period or contract, regardless of production or sales volume (within a relevant range). These costs are often contractual or scheduled and represent the base-level expenses required to operate a business.

Common examples

• Rent and lease payments
• Insurance premiums
• Interest expense on debt
• Property taxes
• Depreciation and amortization
• Salaries for management or permanent staff
• Some utilities and maintenance when billed at a flat rate

How fixed costs appear in financial statements

• Income statement: recorded as indirect/operating expenses (e.g., depreciation, administrative salaries).
• Balance sheet: related assets are depreciated; some fixed costs may be reflected as short- or long-term liabilities.
• Cash flow statement: cash paid for fixed expenses appears in operating (or financing) cash flows.

Fixed vs. variable costs

• Variable costs change directly with production or sales (raw materials, piece-rate labor, shipping, commissions).
• Fixed costs remain unchanged with output in the short term.
• Semi-variable (or mixed) costs combine both elements: fixed up to a threshold, then variable (for example, a utility with a base charge plus usage fees).

Effects on unit cost and economies of scale

Per-unit fixed cost falls as production increases because the same fixed expense is spread over more units. This contributes to economies of scale: higher output can lower per-unit total cost if fixed costs remain constant.

Important metrics and formulas

Breakeven point (units)
Breakeven Point = Fixed Costs / (Sales price per unit − Variable cost per unit)

Operating leverage
Operating leverage measures how a change in sales affects operating profit. A higher proportion of fixed costs increases operating leverage.

Operating Leverage = (Q × (P − V)) / ((Q × (P − V)) − F)
where Q = units, P = price per unit, V = variable cost per unit, F = fixed costs

Fixed-charge coverage ratio
A solvency metric that assesses the ability to meet fixed-charge obligations:

Fixed-charge coverage ratio = (EBIT + Fixed Charges Before Tax) / (Fixed Charges Before Tax + Interest)

Fixed cost ratio
A simple measure: Fixed Costs / Net Sales — useful to gauge the share of fixed costs in revenue.

Accounting and classification notes

• Fixed costs are typically treated as indirect (overhead) costs and are allocated across periods rather than expensed entirely when incurred (e.g., depreciation).
• Whether a cost is classified as fixed or variable can depend on industry and management’s accounting choices.
• Fixed costs are constant only within a defined relevant range; outside that range (e.g., major capacity changes), fixed costs can change.

Sunk costs

Sunk costs are past expenditures that cannot be recovered. While all sunk costs are fixed in accounting terms, not all fixed costs are sunk — some fixed costs can be altered or avoided in the future (e.g., by renegotiating leases).

Managing fixed costs

• Monitor cost structure with dashboards and regular analysis to understand the fixed-to-variable mix.
• Use breakeven and sensitivity analysis to inform pricing, capacity, and investment decisions.
• Consider flexibility (e.g., outsourcing, variable-rate contracts) to convert some fixed costs to variable when appropriate.
• Track fixed-charge coverage to ensure solvency and ability to service fixed obligations.

Bottom line

Fixed costs are the recurring expenses a business must cover regardless of short-term output. Understanding their size and behavior relative to variable costs is essential for pricing, profitability analysis, capital planning, and managing financial risk.