Understanding fixed costs in a business

Understanding fixed costs and how they impact the day-to-day running of a business is essential for anyone looking to start or expand their operation.

Think of fixed costs as those expenses that are always there, no matter how much gets sold. Typical examples of fixed costs in a business include office or shop rent, employee salaries, property taxes, and any licenses or professional memberships.

This article breaks down everything an entrepreneur should know about fixed costs, what they are, how to calculate them, and their role in financial statements.

What are fixed costs?

Fixed costs are expenses that stay the same regardless of how much a business makes or sells.

Predictable and consistent, these fixed costs make budgeting, forecasting, and cash flow management easy as expenses remain the same and roll in at regular intervals.

Unlike variable costs, fixed costs do not change with the production or service delivery volume. For example, rent remains the same monthly whether the factory produces 100 or 1,000 units.

What are fixed overhead costs?

Fixed overhead costs are expenses that come in regardless of business performance. They are often related to keeping the lights on and the business operating.

Not all fixed costs are overhead costs. Rent, for example, is an overhead cost, while non-overhead fixed costs include things like loan repayments. These are not considered overhead costs because, while they are business-related, they do not contribute to the day-to-day operations of the organization and are instead associated with financing decisions.

Fixed costs vs. variable costs

What are variable costs?

Variable costs are expenses that go up or down depending on how much a business produces or sells. Common examples of variable costs include sales commission, employee overtime, raw materials, and delivery or freight fees.

Fixed costs vs. variable costs

While fixed costs do not change with the volume of production or sales, variable costs vary depending on the levels of business activity. For example, the more units manufactured, the greater the cost of raw materials, energy, and freight to produce the increased number of units.

Informed business decisions

Understanding the difference between fixed and variable costs can dramatically impact future business decisions and a company's profitability.

Indeed, they impact planning, budgeting, forecasting, and even pricing decisions. For example, a business with higher fixed costs, like rent, may want to boost sales volumes to spread this cost over more units, reducing the cost per unit overall.

For example, if a store is in a desirable high-end neighborhood with lots of foot traffic, rent will likely be higher than if they were located elsewhere. This shop owner must consider their pricing and whether they can spread these costs across their product range, passing the higher costs onto their customers.

When planning profitability, understanding these differences will give a business owner clear insight into the minimum revenue needed to cover the essentials, highlighting which variable costs they should prepare for.

How to calculate fixed costs

Calculating fixed costs is fairly straightforward. The following steps explore two approaches a business can use to calculate its fixed costs:

The fixed cost formula

  1. List fixed expenses: Begin by listing every expense that stays the same, no matter what level of production or sales occur: rent, mortgage payments, employees, etc.
  2. Combined expenses: Add these fixed costs together to discover the total sum of all the business expenses over a given period. Fixed Costs = Fixed Cost 1 + Fixed Cost 2

The variable cost formula

  1. Calculate variable expenses: This method works by first calculating total variable costs. It is achieved by multiplying the variable costs per unit by the total number of units produced.
  2. Deduct total variable costs: With the total variable costs now known, subtract this figure from the total of all other business costs. The sum left over represent the fixed business costs. Fixed Costs = Total Cost - Total Variable Costs.

Managing fixed costs

Effectively managing fixed costs is essential for a business's financial health and growth. Understanding their impact can significantly enhance a business's ability to thrive.

Budgeting and financial projections

Accurately tracking fixed costs provides a predictable base for any business to forecast future expenses. By understanding each fixed cost, they can set realistic sales and revenue targets to cover the costs and turn a profit.

While necessary for every business, this is particularly important when planning for seasonal businesses or those facing fluctuation in sales.

Financial statements

Typically recorded in the profit and loss statement, they are labeled as operating expenses and deducted from gross profit to arrive at the operating profit.

Unlike variable costs, fixed costs will not directly show in the cost of goods sold but are considered part of the broader operating expenses.

Financial stability and growth decisions

Fixed costs are critical to a business's financial health. A company needs steady income to stay afloat if these costs are high. Knowing all the fixed costs is crucial when thinking about growth. This knowledge helps decide whether expanding, exploring new markets, or investing in big projects is practical.

Allocating revenue to fixed costs

How much revenue should flow into fixed costs varies by industry and business model.

A good rule is to keep fixed costs reasonable compared to total revenue. Keep regular tabs on fixed costs to ensure they are not disproportionately high relative to your income.

This process may involve renegotiating contracts, reducing expenses, or seeking other cost-effective solutions. Although this can vary, it’s usual for businesses to keep fixed costs between 30-50% of total revenue. Keeping them within this range can help maintain flexibility and resilience against fluctuations.

Tracking and managing fixed costs

Understanding and managing fixed costs is vital to running a successful business. Keeping these costs in check can help a business stay stable and prepare for growth. To make handling these finances easy, consider PayPal for Business and get more analytics insights in our Business Resource Center.

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