Fixed overhead

What Is Fixed Overhead?

Fixed overhead refers to the indirect costs incurred by a business that do not change, regardless of the level of production or sales volume. These expenses are essential for a company's operations and must be paid even if no goods or services are produced. Fixed overhead is a fundamental concept within managerial accounting, providing crucial insights for managerial decision-making related to pricing, production, and profitability. Common examples of fixed overhead include rent for factory space, annual insurance premiums, salaries of administrative staff, and depreciation on machinery.

History and Origin

The concept of distinguishing between different types of costs, including what we now call fixed overhead, evolved significantly with the rise of industrialization. As manufacturing firms grew in complexity during the Industrial Revolution, particularly in the late 18th and early 19th centuries, there was a growing need for more sophisticated cost accounting techniques. Early contributors to this field, such as James Dearden in the 1830s, introduced ideas of standard costs and cost control to track expenses in the textile industry. The development of managerial accounting, which encompasses the analysis of fixed overhead, has its roots in this period, as companies sought to measure and control production costs efficiently. This historical trajectory reveals that managerial accounting emerged from cost accounting to address the evolving needs of organizations for internal decision-making beyond just financial reporting.⁶

Key Takeaways

• Fixed overhead represents costs that remain constant regardless of production volume, such as rent and salaries.
• These costs are crucial for budgeting and financial planning, as they must be covered even during periods of low activity.
• Fixed overhead influences a company's break-even point and pricing strategies.
• Understanding fixed overhead is vital for assessing a business's operational leverage and overall asset base.
• While fixed, these costs can lead to greater economies of scale as production increases, lowering the fixed cost per unit.

Formula and Calculation

While total fixed overhead remains constant within a relevant range of production, the fixed cost per unit changes as production volume fluctuates. The formula for fixed cost per unit is:

For example, if a company has $10,000 in total fixed overhead and produces 1,000 units, the fixed cost per unit is $10. If production increases to 2,000 units, the fixed cost per unit drops to $5, demonstrating the principle of economies of scale. This calculation is distinct from capital expenditures, which represent investments in long-term assets.

Interpreting the Fixed Overhead

Interpreting fixed overhead involves understanding its implications for a company's financial health and strategic options. High fixed overhead means a company needs to achieve a higher sales revenue or production volume to cover these non-negotiable expenses and reach its break-even point. This can lead to significant operating leverage: when sales are strong, profits can increase dramatically because the fixed costs are spread over more units. Conversely, during downturns or periods of low production, high fixed overhead can lead to substantial losses because these costs persist despite reduced activity. Businesses must ensure sufficient cash flow to cover these predictable expenses, even during slow periods.⁵

Hypothetical Example

Consider "BuildWell Co.," a small construction equipment rental company. Its fixed overhead includes $5,000 per month for office rent, $3,000 for administrative salaries, and $2,000 for insurance, totaling $10,000 in fixed overhead.

In July, BuildWell Co. rents out 100 pieces of equipment. The fixed overhead per piece of equipment is:

In August, due to increased demand, BuildWell Co. rents out 200 pieces of equipment. The total fixed overhead remains $10,000. Now, the fixed overhead per piece of equipment is:

This example illustrates how an increase in volume can decrease the per-unit fixed cost, positively impacting the company's profitability.

Practical Applications

Fixed overhead is a critical component in various aspects of financial analysis and strategic planning. In financial statements, particularly the income statement, fixed costs are typically categorized under operating expenses, influencing reported profit. Businesses use fixed overhead in cost-volume-profit analysis to determine the volume of sales needed to cover all costs and achieve a desired profit. This analysis helps in setting appropriate pricing strategies; companies with high fixed costs may need to charge higher prices or focus on increasing sales volume to cover these expenses. Understanding fixed overhead is also essential for make-or-buy decisions, where a company evaluates whether to produce a component internally (incurring fixed production costs) or outsource it.⁴

Limitations and Criticisms

While fixed overhead provides stability and predictability in financial planning, it also comes with certain limitations. One primary challenge is the lack of flexibility. These costs remain constant even during periods of low activity or economic downturns, meaning businesses must bear them regardless of sales. This inflexibility can put significant strain on a company's finances during challenging times.³ For instance, a manufacturing company with a factory lease must pay the fixed monthly rent even if production ceases.

Another limitation is the difficulty in reducing fixed overhead in the short term. Unlike variable costs, which can be adjusted based on production needs, fixed costs often involve long-term commitments and contracts that are not easily renegotiated or terminated without penalties.² Moreover, if a business fails to operate at a certain minimum production rate, the per-unit fixed cost increases, negatively impacting profitability margins.¹

Fixed Overhead vs. Variable Costs

Fixed overhead and variable costs are the two primary classifications of business expenses, and understanding their distinction is crucial for financial analysis. The key difference lies in how they react to changes in production volume.

Fixed overhead, as discussed, remains constant within a relevant range of production. Whether a company produces one unit or a thousand, the total rent for its factory, for example, stays the same. These costs are incurred even if production is zero.

In contrast, variable costs fluctuate directly with the level of production. Examples include raw materials, direct labor tied to production volume, and sales commissions. If a company produces more units, its total variable costs will increase; if production decreases, total variable costs will fall.

The confusion often arises because, on a per-unit basis, fixed overhead decreases as production increases, while variable costs per unit typically remain constant. This distinction is vital for accurate contribution margin calculations, which subtract variable costs from revenue to determine the amount available to cover fixed costs and generate profit.

FAQs

What are common examples of fixed overhead?

Common examples of fixed overhead include rent, insurance premiums, salaries of administrative staff, property taxes, depreciation on equipment, and interest payments on loans. These expenses are typically recurring and must be paid regularly.

How does fixed overhead impact a business's break-even point?

Fixed overhead significantly impacts a business's break-even point, which is the level of sales where total revenue equals total costs, resulting in zero profit. The higher the fixed overhead, the greater the sales volume required to cover those costs before the business starts generating a profit.

Can fixed overhead ever change?

While fixed overhead remains constant within a specific "relevant range" of activity and over a defined period (e.g., a month or year), it can change over the long term or if the business significantly alters its operations. For example, signing a new lease with higher rent, purchasing new machinery (affecting depreciation), or expanding operations can change total fixed overhead.