Costs which do not change despite variations in the amount of business activity are known as fixed costs. Whether a company makes one item or one thousand items, the amounts which are payable for its fixed costs will remain the same.
Where possible businesses should seek to minimise the number of expenses which fall in to the category of being fixed, particularly when starting up and it there is great uncertainty as to how many sales will be made.
With a higher proportion of variable expenses, the business is more flexible and can adapt its cost structure based on the volume of sales it is attaining in any given period.
Conversely, businesses which has to meet a high volume of unit sales before becoming profitable are more susceptible to downturns and shortfalls. Their cost structure thus remains virtually unaltered whilst their production and sales figures plummet.
Fixed costs form part of the equation for calculating the break-even figure for a business and in adding the total contribution made by sales must be covered in order for the operations to generate a profit.
The general classification of whether a particular expense is fixed or variable is the availability which exists to change it in the short term. All costs are variable in the longer term but agreements and contracts signed by the business may make some expenses obligatory and therefore unchangeable in the immediate period.
Some typical examples of fixed costs are as follows:
- Rent of offices or buildings are often fixed costs and are payable irrespective of how much business production occurs.
- Some wages and salaries, particularly those involved in the management, administrative and support role are fixed and are their payment is often not dependant upon production levels.
- Machinery lease charges, where the contract term is for a number of years represent a non variable expense to a business.