What’s it: Fixed costs are types of costs whose value is unaffected by changes in the amount of output. When a firm increases output or decreases output, it does not change.
For example, the factory machine’s rental cost is $15,000,000 for 1 year. It has a production capacity of 240,000 units per year. Rental costs will remain the same regardless of production realization, reaching 230,000 units or only 100,000 units for a year.
Why fixed costs matter
Fixed costs, together with variable costs, make up the total costs of doing business. Unlike fixed costs, variable costs fluctuate as production or sales increase or decrease.
Understanding business fixed costs is important for maximizing profit. Companies usually use it to calculate the breakeven point, which is the point where revenue equals costs. The breakeven analysis results are essential for determining the minimum production volume and setting the selling price.
The high fixed costs increase the breakeven point. That means the company has to sell more volume to cover fixed costs or charge a higher price. Because of its unchanging nature, the company must still pay for it even if production rises or falls.
Fixed cost effects on economies of scale
Firms have to pay variable and fixed costs to produce. Total variable cost will change proportionally as output increases or decreases. Likewise, the variable cost per unit will also fluctuate with changes in output.
Conversely, although total fixed costs are constant, fixed costs per unit (total fixed costs divided by total output) will decrease as output increases. And, when the output goes down, it goes up.
Firms could achieve economies of scale and lower fixed costs per unit of output by increasing production. That way, they can spread the total fixed costs over a large number of outputs. For example, if a pencil manufacturer produced 100,000 units, the advertising cost per unit of output would be $50. The total cost of advertising is $5,000,000 (100,000 x $50).
If the company increases production to 200,000 units, the advertising cost per unit of pencil halves to $25.
When it has high fixed costs, we say that the company has a high operating leverage degree. To operate profitably, a company must sell significant volumes to break even.
An example of a high fixed-cost company is a utility company. This company has to make a significant investment in infrastructure. To compensate for the fixed costs, the company must produce at a significant rate.
Once the company breaks even, then any increase in production or sales will result in higher profits, ceteris paribus. But, when sales volume falls, or prices fall, it will depress profitability significantly. For this reason, they are vulnerable to competitive pressures.
The effect of fixed costs on competition
In industries with high fixed costs, competition between firms tends to intensify. Each of the players must achieve a massive sale to break even and make a profit. They will fight over market cakes and try to steal market share from competitors.
Competitive pressures get stronger when demand in the industry slows down, for example, due to a recession. They will tend to cut prices below average cost, even close to marginal cost, to steal customers from competitors while covering fixed costs.
After the commodity boom in the 2012s, weak demand is why metal prices have continued to decline. Many commodity companies suffered losses. They face a high build-up of goods in the warehouse. They then try to increase sales by lowering the selling price.
Furthermore, the high fixed costs also justify monopolies in some industries, such as electricity. In such an industry, having more players is unfavorable for consumers. Selling prices will tend to be higher because they cannot lower average costs and achieve economies of scale.
Conversely, if there is only one firm, the monopolist can lower costs and sell at a lower price. Usually, it is under government supervision to ensure that the selling price is fair.
Examples of fixed costs
The types of fixed costs vary depending on the nature of the company business. A service company will have a much different fixed cost structure than a manufacturing company. Likewise, a manufacturing company will also have a different cost structure from an electric company.
Example of fixed costs for a manufacturing company:
- Interest costs. When companies borrow from banks, they will issue regular money to pay interest on the loan. Likewise, when issuing bonds, they must pay coupons regularly until maturity.
- Utility costs such as water, electricity, and telephone. Some may have variable elements, especially those directly related to the production process.
- Depreciation of fixed assets. It is a gradual expensing cost over the useful life of the asset. Unlike other expenses, it does not involve cash outflows because it only represents a decrease in the asset’s economic benefit.
- Non-production employee salaries. For example, the salaries for marketing, accounting, information technology, and human resources divisions. This includes the salaries of company executives.
- Rental property and real estate. Companies must periodically pay office or warehouse rent to asset owners regardless of whether they use them or not.
- Insurance fee. The company pays periodically under an insurance contract.
- Maintenance e costs for machines and equipment. Manufacturers regularly incur these costs to optimize these assets’ use and reduce potential bottlenecks in the production process.
Some types of fixed charges may be tolerable. I mean, companies can still reduce or eliminate them without having a significant impact on operations.
For example, a pencil manufacturer spends $5 million to advertise its products. Advertising is a fixed cost. The company can reduce it or stop advertising altogether and can still sell pencils.
Meanwhile, some other fixed costs cannot be avoided, and the company has to pay for them. An example is the interest cost for a loan from a bank.