Every business incurs costs during its course of operations. These expenses are categorised into fixed costs and variable costs. It is important for businesses to understand how to calculate fixed costs in order to correctly price their goods and services.
What are Fixed Costs?
Fixed costs are a type of expense or cost that remains unchanged with an increase or decrease in the volume of goods or services sold. They are often time-related, such as interest or rents paid per month, and are often referred to as overhead costs. They are important to attaining more profit per unit as a business produces more units.
Along with variable costs, fixed costs are one of the two components of the total cost of a good or service offered by a business. They are business expenses that do not change as the level of production fluctuates. On the other hand, variable costs are considered volume-related as they change with the output.
What is the fixed cost formula?
Fixed cost is any kind of business expense that does not alter based on production or sales. Sometimes, fixed costs are also called indirect costs or overhead. The business can not change fixed costs to reduce expenses. Instead, they usually depend on an outside entity, like a landlord or bank. Rent, insurance and labour cost are all examples of fixed costs. Variable costs are business expenses that can change based on sales or production. Merchandise materials and utilities are examples of variable costs.Usually, businesses calculate the total fixed cost or overall expenses of all individual fixed costs over a short period, such as monthly or half-yearly. While the expenses associated with fixed costs may not change based on sales, they may go up or down depending on other factors. For example, your landlord may increase the rent of your office with time. This can increase your fixed costs but this increase is not related to production or sales. Thus, it is recommended to calculate only your fixed costs in the short term in case these costs fluctuate.
How to calculate fixed cost
There are two methods for calculating fixed costs. The first method works by using this simple formula:
- Fixed cost = Total cost of production – (Variable cost per unit x number of units produced)
First, add up all production costs. Note which among these are the fixed cost and variable cost. Take your total cost of production and subtract the variable cost of each unit multiplied by the number of units you produced. This gives you the total fixed cost. The second way to calculate the fixed costs is to tally all of your fixed costs and sum them up. Below are the steps to calculate the fixed cost using the tally method:
1. List all costs
Begin by listing all monthly costs your business incurs. You can make a list by using receipts, budgets and bank account transactions. Expenses paid annually should be divided by 12 to calculate the per month expenses. List every expense and the cost of that expense per month, ideally in a spreadsheet.Example: Sri Hari Dolls Ltd. makes toy dolls for children. The business needs to calculate its fixed cost in order to set a reasonable price for its product. They make a list of every expense they have per month.
2. Find fixed cost and separate variable costs
Since you are only interested in the fixed costs, itemise the list of expenses by fixed costs (those that do not change based on production or sales) and variable costs (those that are directly impacted by production or sales).Example: Sri Hari Dolls Ltd. separates its overall list into fixed costs and variable costs. Their fixed costs include building rent (₹ 3,000), employee wages (₹ 80,000), equipment (₹ 2,000) and a website (₹ 200).
3. Add fixed costs
Add together all the individual monthly figures in the fixed cost list. That number represents your monthly total fixed cost.Example: Sri Hari Dolls Ltd. adds up all its individual fixed costs to calculate its total fixed costs:₹ 3,000 + ₹ 80,000 + ₹ 2,000 + ₹ 200 = ₹ 85,200Now, Sri Hari Dolls Ltd. knows they need to account for Rs. 85,200 per month in the price of their dolls. To determine the right price per doll, Sri Hari Dolls Ltd. needs to calculate the average fixed cost.
FAQs
Are All Fixed Costs Considered Sunk Costs?
All sunk costs are fixed costs in financial accounting, but not all fixed costs are considered to be sunk. The defining characteristic of sunk costs is that they cannot be recovered.
How Are Fixed Costs Treated in Accounting?
Fixed costs are associated with a business’s basic operating and overhead costs. Fixed costs are considered indirect costs of production, meaning they are not costs incurred directly due to the production process, such as a cost for parts needed for assembly. However, they do factor into total production costs. As a result, fixed costs are depreciated over time instead of being expensed.
