What are fixed costs?
Fixed costs, also known as overheads, are costs that remain the same regardless of your level of business activity. The opposite of fixed costs is variable costs. These vary according to your level of business output. Modern businesses generally try to keep their fixed costs to a bare minimum. In fact, some businesses, especially SMEs, may have no fixed costs at all.
Examples of fixed costs
Traditionally, the main examples of fixed costs have been related to property and its associated costs (e.g. rent/mortgage, property taxes, utilities and insurance) and labour (e.g. wages and salaries).
Depreciation and amortisation are also fixed costs. Debt repayments can be fixed. They can also be semi-variable costs in that the capital repayments are fixed but the interest is variable.
Today, many businesses aim to keep their fixed costs to unavoidable ones such as depreciation, amortisation and debt repayments. They aim to move all other costs to variable pricing. This trend is both driven by and a driver of the move to the ‘as a service’ business model.
Fixed costs in accounting
Fixed costs are shown in the expenses section of the profit and loss statement. Traditionally, most of these costs would be classed as operating expenses but not part of the cost of goods sold or the cost of revenue. In modern companies, they are more likely to be non-operating expenses, particularly depreciation or amortisation.
It’s also generally possible to see fixed costs on the balance sheet (as liabilities) and on the cash-flow statement. Again, traditionally, they would probably have been mostly operating costs. Now, they are more likely to be investing costs or financing costs.
Fixed costs and break-even analysis
The financial concept of economies of scale hinges on the idea that certain costs remain stable even as production increases. This means that when a business reaches a certain level of production it also reaches a break-even point. As the name suggests, this is when the total cost of business expenses is covered by revenue without any profit.
According to traditional financial modelling, if a company then continues to increase its production, the cost per unit will decrease. Profitability will therefore increase. In principle, the increase could be infinite. In practice, it’s highly unlikely that any company would be able to keep growing indefinitely but could, however, reach a point where both its costs and profitability were optimised.
This calculation can still be done if a company only has variable costs, as long as they are predictable. This allows businesses to calculate how much their expenses will be at any given level of production. It’s often the case that economies of scale do still apply as volumes increase. This is because service providers often benefit from economies of scale themselves and pass some of that benefit on to their customers.
The importance of cost structure
Managing costs has always been important to businesses. Over recent years, there has been a growing emphasis on looking at not just what businesses pay but also how they pay it. Modern businesses increasingly try to minimise both high capital expenditure and high overheads. Instead, they aim to pay for exactly what they need or want at exactly the right time.
For example, they lease assets or use them ‘as a service’ instead of buying them outright. Likewise, they minimise direct labour costs by keeping the number of on-payroll employees as low as possible. This approach does not necessarily reduce costs overall. In fact, it may actually increase them. It does, however, allow for a lot more flexibility and also, very importantly, helps businesses to preserve their cash flow.
That said, it’s vital to recognise that there are still times when it is valid to commit to capital expenditure or fixed costs. For example, there may be times when you want to have an asset customised to your exact needs. Alternatively, you may find that committing to a contract offers meaningful savings over flexible pricing.
Learn more about managing your business costs.