What is a fixed cost

From Flickr by Medieval Armour

In the previous post, I explained what a variable cost is. Now here, let’s look at fixed costs.

A  fixed cost is a cost which does not change with the level of activity of a business. For example, there are some costs that a business will incur even if it is closed – such as buildings insurance. Other fixed costs might include a managers salary or other similar payroll costs which are fixed, taxes or business rates paid to a local authority or rent paid to a landlord.  The term overhead is frequently used with reference to fixed costs.

Although the total fixed cost is that, fixed, as the level of activity of a business increases (more goods made or more services provided) the fixed cost per product/service actually falls. Let’s say for example if a business has total fixed costs of £48,000. If the business sells 24,000 units of product, then the fixed cost per product is £2, but if it can manage to sell 48,000 units of product, then the fixed cost per unit is just £1. As more and more units are made, the fixed cost will become negligible on a per product basis. Thus, I think it is easy to see how the level of fixed costs can affect the level of profit – high fixed costs with low volumes might spell trouble.

Are fixed costs fixed forever? No is the simple answer. As a business increases activity, then quite often more fixed costs are incurred e.g. more managers or a bigger premises. So fixed costs are not “fixed” indefinite, but they are fixed within what is called a “relevant range” of activity. A good example of this kind of effect is employer liability insurance  – normally the cost is fixed with a range of employees (maybe  1-100) and the cost jumps once this range is exceed (i.e. 101 staff or more).