Fixed costs

DEFINITION of fixed costs

Fixed costs are expenses that have to be paid by a company, independent of any business activity.

WHAT IT IS IN ESSENCE

They are one of two main types of cost in connection with companies’ balance sheets. The others are variable costs.

There are many different types in the business. But fixed costs remain the same regardless of whether the business stops producing goods and services or build up production.

It appears in break-even analysis to determine pricing and the level of production and sales. Under which a company generates neither profit nor loss. Fixed and variable together make up the total outgoings of a company. That plays a key role in determining the profitability of some company.

Some of this expenses change in a stepwise manner as output changes. And therefore may not be totally fixed. Also, note that many items of this kind have both fixed and variable components. 

For example, management salaries typically do not vary with the number of units produced. However, if production falls dramatically or reaches zero, layoffs may occur. Economically, all expenses are variable in the end.

HOW TO USE

A company with a relatively large amount of variables may exhibit more predictable per-unit profit margins. More than a company with a relatively large amount of outgoings. This means that if a company has a large amount of fixed costs, profit margins can really get squeezed when sales fall. This adds a level of risk to the stocks of these companies.

Conversely, the same high-expenses company will experience magnification of profits. Because any revenue increases are applied across a constant expenses level. 

Thus, expenses are an important part of profit projections. And the calculation of break-even points for a business or project.

In some cases, high fixed costs discourage new competitors from entering a market and/or help eliminate smaller competitors.

Typically fixed costs differ widely among industries, and capital-intensive businesses obv more long-term outlay than other businesses. Airlines, auto manufacturers usually have high fixed costs. Businesses like website design, insurance generally depend on labor rather than physical assets and are thus don’t have as many expenses.

This is why the comparison of fixed costs is generally most meaningful among companies within the same industry.  And investors should define “high” or “low” ratios within this context.