Fixed expense

Fixed Expense: Definition, Example, and FAQs

A fixed expense, also known as a fixed cost, is a business expense that remains constant regardless of the level of production or sales volume. These costs do not fluctuate with changes in output. Fixed expenses are a core concept in managerial accounting, a branch of finance concerned with providing financial information to management for internal decision-making.⁷⁴ Understanding fixed expenses is crucial for businesses to forecast expenses, set pricing strategies, and make informed budgeting decisions.⁷³

History and Origin

The concept of fixed expenses, as part of cost accounting, emerged significantly during the Industrial Revolution in the late 18th and early 19th centuries. As businesses grew in complexity and scale, particularly in industries like textiles and railroads, the need for more detailed financial information to manage operations became apparent. Initially, most business expenses were considered variable costs, directly tied to production volume. However, with the rise of large-scale manufacturing in the late 19th century, fixed costs, such as investments in machinery and factory space, became increasingly significant.⁷¹, ⁷² Accounting systems evolved to identify and track these stable, non-production-dependent costs, allowing businesses to gain a clearer picture of their financial health and make better decisions regarding pricing and investment.⁷⁰ Jerome Lee Nicholson, who began his professional accountancy practice in New York in 1889, is often recognized as a key figure in the development of cost accounting, which differentiates between variable and fixed costs.⁶⁹

Key Takeaways

• Fixed expenses are costs that do not change with the volume of goods or services produced or sold.
• They are predictable and consistent, aiding in budgeting, forecasting, and cash flow management.
• Common examples include rent, salaries of permanent staff, insurance premiums, and depreciation.
• Fixed expenses are crucial for calculating the break-even point and assessing operating leverage.
• While fixed in the short term, over the long term, all costs can become variable.

Formula and Calculation

Fixed expenses themselves do not have a formula as they are a static value. However, they are a critical component in several financial formulas, most notably in calculating total cost and the break-even point.

The formula for Total Cost is:

Where:

• Fixed Costs: The sum of all fixed expenses for a given period.
• Variable Costs: Costs that change in direct proportion to the volume of production or sales.

The formula for the Break-Even Point in Units is:

Alternatively, using the contribution margin:

Where the Contribution Margin per unit is the sales price per unit minus the variable cost per unit.⁶⁶, ⁶⁷, ⁶⁸

Interpreting the Fixed Expense

Interpreting fixed expenses involves understanding their impact on a business's profitability and operational structure. Since fixed expenses remain constant regardless of production volume, they can lead to economies of scale. As production increases, the fixed cost per unit decreases, potentially resulting in higher profit margins.⁶⁴, ⁶⁵ Conversely, if production levels fall, the fixed cost per unit rises, which can squeeze margins and challenge profitability.⁶³

High fixed costs imply a greater reliance on sales volume to cover these inherent expenses. This directly affects a company's break-even point, which is the level of sales at which total revenue equals total costs. A higher proportion of fixed costs means a higher break-even point.⁶⁰, ⁶¹, ⁶² Businesses with significant fixed expenses often face greater financial risk during economic downturns, as they must still cover these costs even with reduced revenue.⁵⁹ Conversely, if sales are booming, high fixed costs can lead to substantial increases in operating profit, a concept known as operating leverage.⁵⁷, ⁵⁸

Hypothetical Example

Consider "Smoothie Spot," a new juice bar. Their fixed expenses include:

• Monthly rent: $2,000
• Salaries for permanent staff (manager, two part-time employees): $4,000
• Insurance: $200
• Loan repayment for equipment: $500
• Utility bills (base amount, regardless of usage): $300

Total fixed expenses for Smoothie Spot: $2,000 + $4,000 + $200 + $500 + $300 = $7,000 per month.

Even if Smoothie Spot sells zero smoothies in a given month, they still incur $7,000 in fixed expenses. This consistent cost structure underscores the importance of achieving sufficient sales volume to cover these base expenses and eventually generate a profit. To calculate their net profit, they would then subtract their variable costs (e.g., cost of fruit, cups, straws) and these fixed expenses from their total revenue.

Practical Applications

Fixed expenses play a crucial role across various aspects of business and financial analysis:

• Budgeting and Financial Planning: Businesses use fixed expenses to establish predictable cash flows, enabling more accurate budgeting and financial forecasting.⁵⁴, ⁵⁵, ⁵⁶ Knowing these consistent costs is essential for new businesses to calculate their startup costs.⁵², ⁵³
• Pricing Strategy: Understanding the proportion of fixed costs to variable costs helps in setting competitive product or service prices. Companies with high fixed costs may need to aim for higher production volumes to spread these costs and achieve a lower unit cost.⁵⁰, ⁵¹
• Break-Even Analysis: As discussed, fixed costs are integral to calculating the break-even point, which informs businesses about the sales volume required to cover all expenses and avoid a loss.⁴⁷, ⁴⁸, ⁴⁹ This is a fundamental tool for financial viability assessment.
• Investment Decisions: When considering investments in property, plant, and equipment (PPE), businesses analyze how these additions might shift their cost structure, potentially increasing fixed costs in exchange for reduced variable costs.⁴⁶
• Regulatory Filings: Publicly traded companies report their expenses, including fixed costs, in their financial statements. For example, a company like Apple Inc. files annual reports on Form 10-K with the U.S. Securities and Exchange Commission (SEC), which include details on their overall cost structure.⁴², ⁴³, ⁴⁴, ⁴⁵

Limitations and Criticisms

While essential for financial analysis, relying solely on fixed expense categorization has limitations:

• Short-Term Nature of "Fixed": While fixed expenses are constant over a relevant range of production and a specific period (e.g., monthly rent), they are not immutable. In the long run, almost all costs can become variable. A company can choose to expand or contract its facilities, renegotiate leases, or alter its permanent workforce, thereby changing its fixed cost base.⁴¹
• Step-Fixed Costs: Some expenses are "step-fixed," meaning they remain constant within certain production levels but increase in steps once a threshold is crossed. For instance, if a factory needs to add another production line to increase output significantly, this new line's rent or depreciation would represent a step-up in fixed costs.
• Allocation Challenges: In complex organizations, accurately allocating fixed costs across different products or departments can be challenging, potentially leading to misleading cost analysis. For example, the salary of a factory manager might be a fixed expense, but deciding how much of that salary should be attributed to each product can be complex.
• Impact on Agility: A business with a very high proportion of fixed costs may be less agile in responding to significant market downturns. It can be difficult to drastically reduce these costs in the short term, leading to magnified losses when sales decline.³⁹, ⁴⁰ This contrasts with businesses having more flexible cost structures.

Fixed Expense vs. Variable Expense

The primary distinction between fixed expenses and variable expenses lies in their behavior relative to production or sales volume. Fixed expenses, as discussed, do not change as output increases or decreases within a relevant range. Examples include monthly rent, insurance premiums, and salaries of administrative staff or executives.³⁴, ³⁵, ³⁶, ³⁷, ³⁸ These are often considered overhead costs that are necessary to keep the business operational, irrespective of how much it produces or sells.³³

In contrast, variable expenses directly fluctuate with the volume of goods or services produced. If production increases, total variable costs rise; if production decreases, total variable costs fall. Examples include the cost of raw materials, direct labor wages tied to production, sales commissions, and shipping fees.²⁹, ³⁰, ³¹, ³²

Understanding this difference is crucial for decision-making. For instance, in a period of low sales, a business with high fixed expenses will still incur substantial costs, potentially leading to losses. A business with primarily variable expenses, however, can more easily reduce costs by slowing production. This distinction is fundamental to concepts like contribution margin and break-even analysis, where the fixed costs must be covered by the revenue remaining after variable costs are accounted for.²⁷, ²⁸

FAQs

Q: What are common examples of fixed expenses for a small business?
A: Common fixed expenses for a small business include rent or mortgage payments for office or production space, salaries of permanent administrative staff, business insurance premiums, depreciation on equipment, and subscription fees for essential software or services.²⁰, ²¹, ²², ²³, ²⁴, ²⁵, ²⁶

Q: Why is it important to distinguish between fixed and variable expenses?
A: Distinguishing between fixed and variable expenses is vital for accurate financial analysis and strategic decision-making. This differentiation helps businesses to:

• Calculate the break-even point.¹⁸, ¹⁹
• Understand their cost structure.¹⁷
• Make informed pricing decisions.¹⁶
• Evaluate profitability under different sales scenarios.¹⁴, ¹⁵
• Manage cash flow and financial risk.¹², ¹³

Q: Can a fixed expense change over time?
A: Yes, while fixed in the short term, fixed expenses can change over the long term. For example, a multi-year lease agreement might lead to a fixed rent expense for that period, but upon renewal, the rent could increase. Similarly, a company might invest in new machinery, increasing its depreciation expense, or lay off permanent staff, reducing salary expenses.¹¹

Q: Are fixed expenses always listed as "overhead" on an income statement?
A: Fixed expenses are often referred to as overhead costs, particularly those not directly tied to production, such as rent and administrative salaries.⁹, ¹⁰ On an income statement, many fixed expenses are typically categorized under "operating expenses" or "general and administrative expenses."⁷, ⁸ However, some fixed costs, like the depreciation of manufacturing equipment, might be included in the cost of goods sold (COGS) for internal accounting purposes, although this is more common for variable costs.⁶

Q: How do fixed expenses affect a company's ability to scale?
A: Fixed expenses significantly impact a company's ability to scale. High fixed costs can create economies of scale, meaning that as production increases, the cost per unit decreases, making larger production volumes more efficient and profitable.⁴, ⁵ However, they can also act as a barrier to entry for new businesses due to the initial capital outlay required.³ For existing businesses, high fixed costs can make it harder to scale down operations quickly during a downturn without incurring significant losses.

Q: What is the relationship between fixed costs and operating leverage?
A: Fixed costs are a direct driver of operating leverage. A company with a higher proportion of fixed costs in its overall cost structure has higher operating leverage. This means that a small change in sales revenue can lead to a proportionally larger change in operating income. While this can magnify profits during periods of strong sales, it also amplifies losses during sales declines, as the fixed costs must still be covered.¹, ²