Why is it important to understand fixed costs? How is it used in cost accounting and in financial reporting? Finally, what are examples of fixed costs?
Fixed costs are those cash expenses that must be paid whether the business produces or sells a single product. Common examples include rent, insurance, salaries and interest. There is a difference between the cost accounting definition and the financial accounting definition. In cost accounting, fixed costs are offset by the contribution margin. In financial accounting, the gross margin is used to cover fixed costs.
If you are interested in a more in-depth understanding of this term, the following sections are educational based in describing ‘Fixed Costs’.
Explanation of Fixed Costs
In accounting we use the break even point formula to establish some form of minimum production or sales to cover costs. Some of these costs are fixed in nature due to the underlying need or compliance for the item. Above, rent was sighted as an example, but other types of costs that are required include electricity, insurance, interest on debt and more. The key to understanding fixed costs is to think of what would I have to pay if nobody showed up to work this month or I did not sell a single widget, in effect I did nothing to earn money? You can see how rent qualifies; the landlord is going to require payment due to contractual obligation. Your bank will want its note payment; regardless of your production. The insurance company has to be paid as a legal requirement for you to be in business. Property taxes do not take vacations. Get the idea? These are fixed costs.
Each industry is going to have different forms or types of fixed costs. In some industries, salaries are paid even if no work is accomplished. Think of the hospital, it still needs doctors and nurses even if no patients show up at the emergency room. In some small businesses, the staff is salaried. Even though you may not sell any product, they still have to be paid.
The underlying principle of a fixed cost is the expense requires payment no matter what happens.
This is where the break even point comes into play. The idea is that every product or service provided has some form of a variable and fixed cost. A good example is the fast food restaurant. Prior to the patron walking in to order lunch, the staff is in place, the fryer is heated up, the grill is ready, the lights are on and the restaurant is ready to serve. The only variable cost associated with the customer’s order is the food itself (OK, maybe the paper for the receipt). If the customer pays $1.00 for a drink and it costs the restaurant 40 cents to cover the syrup and soda water, the sale generates 60 cents as contribution to offset all those other costs. You need to sell a lot of food to cover all those fixed costs that day.
This example is used in cost accounting to define contribution margin. In effect it states: sales less variable costs equals contribution margin. The contribution margin is used to offset or cover those fixed costs. Plus any profit desired.
No matter what, you will have to pay fixed costs. Even if you sold that soda for 41 cents, you at least contributed one penny towards fixed costs. This principle is why many fast food restaurants are involved in serving breakfast. The costs of the rent, insurance, taxes, security, legal compliance and so on are partially offset by the contribution margin from breakfast sales.
Now that you understand what a fixed cost is, you need to understand its importance in business. Pricing your product or services determines the amount of contribution margin you will generate to offset fixed costs. The sooner you offset the fixed costs within the accounting period, the sooner you’ll generate a profit. Remember, a profit is defined as Revenue less Expenses (Costs). Those expenses can all be grouped into two categories: fixed and variable. There is a third and it is the two combined but for now, you need to understand the two basic groups.
Going back to our soda sale example above, if sold you that soda for $1.20; we now have a contribution margin of 80 cents. You will now cover those fixed costs faster in the restaurant as opposed to the 60 cents contribution margin. You need to be thinking like this in your business.
In some industries, fixed costs are extremely high in comparison to the price of the service or product sold. Examples of high fixed cost operations include professional services (expensive compensation packages to the highly educated staff) and medical services (custom facilities, highly compensated staff, licensing, software and compliance). Others include education (again note the highly compensated staff) and manufacturing (cost of facilities, equipment).
At the other end of the spectrum are low fixed cost businesses. These include construction companies (the variable costs are materials and labor), personal service businesses (labor is the variable cost) and gasoline stations. In a typical one gallon of gas sold, the station earns about 18 cents. Out of a $3.25 per gallon sale, the contribution margin is very low. In this case the station needs volume in order to cover their associated fixed costs. This is why you are seeing more and more stations with a vast number of pumps. They need volume to cover fixed costs.
Depending on the nature of your business, your fixed costs have to be covered by the contribution margin generated from each sale.
Cost and Financial Accounting
Remember this article started out by stating that ‘fixed costs’ is a term used mostly in cost accounting. Cost accounting associates contribution margin with the underlying elements of the particular service or product unit sold. In the gasoline example, the sale of one gallon is $3.25, the variable costs include the gasoline itself and the taxes the station must pay to the federal government, state government, regional transportation authority and so on associated with the sale of that gallon. Its contribution margin (revenue less variable costs) equals about 18 cents. Well, in financial accounting, it is somewhat similar except for a couple of elements.
First off, it is done on much larger scale and it refers to the entire operation. In financial accounting, the variable costs are generally included in the cost of goods sold section of the profit and loss statement. The fixed costs are found in the expenses section. Review this simple example below related to that gas station.
Costs of Good Sold:
Taxes (Fed, State, Local) 16,270
Gross Profit 23,048
Office Operations 985
Interest on Debt 7,391
Net Profit $5,558
Naturally, the real financial statement would be much more itemized and extended. It was kept simple for educational purposes. The idea is that in general, the fixed costs are located in the expenses (overhead) section. Some financial statements will have fixed costs in the cost of goods section. This doesn’t mean they are wrong, it means that in that particular industry, this is where it is reported. But for the purpose of introducing the subject matter to you, fixed costs are located in the expenses section of the profit and loss statement.
Just remember, in cost accounting, fixed costs are associated with the production or sale of the individual units. In financial accounting, fixed costs are associated with the expenses of the overall operation. In addition, in financial accounting there are accrual based costs that are considered fixed such as depreciation and amortization. However, in the true sense of the fixed costs definition, fixed costs relate to the cash basis of accounting and not accrual accounting.
An example of comparing cost and financial accounting is the salary of the management team. I’ll use the human resources director as an example. In cost accounting, the fixed cost of the human resources manager is not included, whereas in financial accounting, that position’s cost is indeed included in the report.
Fixed costs are used in other areas of business too. Sometimes businessmen use it to describe their ‘Sunk’ costs which include all capital outlays including research and development. This is not technically correct, but it is used and is considered an acceptable interpretation in the general business world. For accountants, they are more restrictive in the meaning but understand when business owners discuss their unique situations and use this term loosely.
To help you clarify what is a fixed cost and what is not, the following list will identify and describe several different costs and if they qualify as a fixed cost:
- Rent or Mortgage Payment – definitely fixed,
- Salaries – fixed because they have to be paid no matter what,
- Benefits – if required based on the employee agreement, then they are fixed,
- Interest – fixed,
- Insurance – if no limits to volume; then it is fixed in nature. But only the insurance that is mandated by law, all other insurance is not fixed because there is not legal requirement to obtain that insurance. Remember, insurance is a risk reduction tool and is generally a voluntary expense. See Introduction to Insurance for a clearer understanding of insurance and risk.
- Utilities – in general they are partially fixed in nature. Some operations require the electricity at all times, think of frozen food storage; you have to have the electricity. But in many business operations, the utilities increase as the production increases or operations ensue. In cases like this, utilities are considered variable. The answer is ‘it depends on the business model’.
- Depreciation – NO, not fixed. Why? Well, depreciation is a non-cash function of business. It is associated with the purchase of fixed assets which are a function of capital expenditures. Let me forewarn you, you can ask 1,000 accountants and you’ll get about 980 of them to state that it is indeed fixed. They are wrong! Fixed costs relate to actual cash out for the associated cost. Depreciation relates to a sunk cost which had cash out at the point of purchase of the fixed asset. Remember that ‘fixed costs’ is mostly a cost accounting term? Well, cost accounting relates to actual cash issues during production and not accrual based issues. Remember the contribution margin concept – Sales less variable cost(s) equals contribution margin. The contribution margin is offsetting actual cash fixed costs. A different way of stating this is: What would I have to pay (cash out) if I produced nothing or sold zero products? Depreciation is not a cash basis cost. This is one of those nuances between cost accounting and financial accounting. In the accrual based world of financial accounting, depreciation is accepted as a fixed cost (those 980 accountants). For the other twenty of us, nope, fixed costs relate to cash basis accounting only.
- Equipment Rental – fixed in nature if used for an extended period of time over many units of production. If short term and only for the purpose of contractual compliance to produce a single lot of products, then it is a variable cost.
Conclusion – Fixed Costs
Fixed costs are those cash out required expenses paid regularly and must be paid regardless of production or earnings from sales. The key is: What would I have to pay if I sold or produced nothing during the accounting period?
The term is mostly acquainted with cost accounting and is defined as those costs that are paid out no matter how many widgets are produced.
There is a difference in its meaning between cost and financial accounting. Financial accounting takes into consideration all elements of the business operations and cost accounting limits itself to actual production of the widget. The cost of the accountant sitting in the back room with his adding machine had nothing to do with the physical production of the widget, therefore his salary is not included in cost accounting. However, in financial accounting, his salary is a fixed cost and is included in the report. Act on Knowledge.