How to Calculate Fixed Cost? Formula, Guide and Examples

All businesses must face different kinds of costs throughout their operation, which can be grouped into fixed cost or variable cost. Understanding fixed cost is of great importance for companies to price their goods or services reasonably.

In this article, you will learn about fixed costs, how total fixed costs and average fixed cost can be measured, examples of fixed cost, as well as pros and cons of fixed cost.

Without further ado, here is the definition.

What is fixed cost?

Fixed cost is the expense that does not change in tandem with changes in demand or revenue over a certain period of time. Fixed cost is independent of the number of business activities because it is more of a periodic cost. Fixed costs are also referred to as indirect costs or overhead.

The business cannot change their fixed costs even if they decide to decrease operating expenses. Instead, fixed cost is usually set by an external body like a property owner or bank. Rent fees, insurance, and staff’ salary are some examples of fixed costs.

Total fixed cost, or the overall expense of every kind of fixed costs, is usually calculated over a short period of time, for example, a month or half a year. Although the amount of money linked with fixed costs may not vary based on sales, they will increase or decrease depending on other variables. Your landlord, for instance, can raise the lease on your office. Your operating expenses will increase, but this increase is not related to production or revenue. Thus, as these costs vary, it is advised to measure only the fixed costs in the short term.

Fixed cost is one of the two main contributors to the overall production cost. On the other hand, variable cost is business expenses that can vary depending on demand or revenues. Goods’ materials and facilities are examples of variable costs.

Think of the variable cost and fixed cost this way. As an adult, you may need to pay a monthly rent or contract, electric bill, vehicle payment, housing, travel costs, and groceries. Expenses like groceries, petrol expenditures, and childcare will increase if you have children, and these expenses are your variable costs

Although your variable costs escalate after having a family, for as long as you are in the same home and ride the same vehicle, your monthly mortgage, utility bill, travel expenses, and car payment do not change. These expenses are your fixed costs, and no matter what adjustments you make to your schedule, you pay the same price.

Likewise, let’s say a startup e-commerce business pays for warehouse space to manage its inventory and 10 customer service employees to handle order inquiries. But all of a sudden, it signs a contract that requires another five paid customer service reps. The labor’s variable costs of this startup rise, while warehouse’s fixed cost remains the same.

What is average fixed cost?

Average fixed cost, also referred to as fixed cost per product, assigns each piece of merchandise a cost to compensate for all the fixed costs needed to operate the company.

Average fixed cost gives you an idea of how much the company is supposed to be paying every time a unit of a commodity is produced — before considering the variable costs in order to actually manufacture it. Average fixed cost allows companies to decide a price point on their goods. Knowing the average fixed cost is vital because if it is not reflected in the price of the company’s commodity, that company will not make any profits.

Examples of fixed cost

If you have come this far, you have probably got the gist of a handful of fixed cost examples we are already paying as individuals, things like your monthly mortgage, utility bill, travel expenses, and car payment, etc.

However, fixed cost for your company is another story. Your company could incur a variety of fixed costs that you barely pay in your personal life. In fact, some variable costs for people are fixed costs for companies.

Calculation of your fixed costs is definitely not the most enjoyable part of growing your business. But understanding what they are and when you need to pay for each of them gives you the financial security you need to serve and satisfy your customers.

For every emerging business to bear in mind, here’s a master list of fixed costs:

• Lease on office space: The leasing cost will not change as long as the company runs in the same building.

• Utility bills: As the weather condition varies, the heating or cooling cost will fluctuate, and it usually is not influenced by business activities.

• Website hosting costs: You pay a tiny monthly fee when you register your website name, which stays unchanged no matter what businesses you are doing on that website.

• Hosting systems for e-commerce: You may need an e-Commerce platform connected with the website to conduct transactions with your online customers. Currently, e-Commerce platforms charge a moderate fixed cost per month.

• Warehouse space lease: You pay for warehouses the same way you pay your office space rent. It doesn’t matter that you store more or fewer products inside, the price will stay the same but can have restrictions on storage and capacity.

• Manufacturing equipment: Once you purchase it, the equipment you need to produce your item is yours, but it will deteriorate over its lifetime. If you have to replace your equipment each year, facilities’ depreciation can become a fixed cost.

• Lease on shipping trucks: Truck leases work the same way as paying for a car. It will not vary depending on how many products you ship per truck.

• Labor: the human work needed to make a good or service is called labor. Typically, labor expenses are labeled as payroll, and the taxes that come with it.

• Licensing or Permits: For specific organizations to work lawfully, permits and licenses are mandatory. The type of license and the permit’s overall cost varies depending on what your business produces or does. For instance, a liquor license is a must for restaurants or bars that sell alcohol.

• Maintenance service: Maintenance includes a number of costs. It may refer to as cleaning service, machine tools’ repair expenses, or annual maintenance for vehicles.

• Loans: Most companies take out loans. Hence, monthly or yearly loan payments are a fixed cost.

Advantages and disadvantages of fixed cost.

Advantages of fixed cost

• Throughout a company’s manufacturing process, fixed costs will remain at the same level until any major capital spending is made. For example, if a company buys and implements a machine, after that, the company will have to pay a fixed depreciation costs every year regardless of the level of production.

• Fixed cost is significantly more comfortable for companies to gain back as it does not change in tandem with the number of products made or sold.

• Although it does not change in tandem with an increase in production quantity, fixed cost decreases the more you produce, which can encourage your companies to produce more.

• Manufacturing output and costs mostly remain the same.

• Fixed cost lowers a company’s taxable profits for the accounting year, resulting in a lowered tax burden that cascades to cash savings.

• Cost-intensive companies act as a deterrent to new competitors from joining the market and eliminate smaller rivals.

Disadvantages of fixed cost.

• One of the main pitfalls is if a company struggles to run at a certain minimum production rate, fixed cost per unit will increase. If a corporation has a colossal amount of fixed cost, the profit margins will be squeezed by a decrease in production or market volume.

• When the business is producing several types of products, it will be harder to find clear connections between the product and the fixed cost. Consequently, the distribution or apportion of cost is done based on each division’s financial performance, which can lead to wrong financial performance analysis.

Formula to calculate Fixed Cost and Average Fixed Cost.

Formula to calculate Fixed Cost

We can derive the Fixed Cost formula by first multiplying the number of units produced and the variable production cost per unit, then subtracting the result from the overall production cost. It is interpreted mathematically as below

** Fixed Cost = Total Cost of Production – Number of Units Produced * Variable Cost Per Unit **

Formula to calculate Average Fixed Cost.

Average fixed cost gives you an idea of how much the company is supposed to be paying every time a unit of a commodity is produced — before considering the variable costs in order to actually manufacture it.

Average fixed cost allows companies to decide a price point on their goods. Knowing the average fixed cost is vital because if it is not reflected in the price of the commodity of the company, that company will not make any profits.

Explanation and Examples

Explanation.

You can calculate the formula for fixed costs by using the following steps:

Step 1: First, calculate the variable production cost per unit, which may be the sum of different production costs, such as labor costs, raw material costs, commissions, etc. These costs are variable in nature and change as the production rate or market volume rises or decreases.

Step 2: Then, calculate the number of units made during a fixed production period.

Step 3: Multiply the variable cost per unit (step 1) and the number of unit production (step 2) to get the total variable cost of production.

Total Variable Cost of Production = Variable Cost Per Unit * No. of Units Produced

Step 4: Determine the total cost of production of the company during a time period (aka. the total of all costs combined during production cost)

Step 5: Finally, calculate the total fixed production cost by subtracting the total variable cost in step 3 from the total production cost in step 4. You can see the formula below.

Fixed Cost = Total Production Cost – Variable Cost

or

Fixed Cost = Total Production Cost – Number of Units Produced * Variable Cost Per Unit

Examples

Example 1:

Let us look at the XYZ Toy Company. The number of toys produced in May 2020 is 20,000, according to the production manager. The total cost of production for that month was $100,000 according to its accounts department. Calculate the fixed production cost given the average variable cost per unit for XYZ Toy Company is $3.

Solution:

We have

Total cost of production = $100,000 (A)
Variable cost per unit = $3.00 (B)
Number of units produced = 20,000 (C)

We can calculate the fixed cost of production of XYZ Toy Company for May 2020 as follows.

Fixed cost of production of XYZ Toy Company = A – B*C = 100,000 – 3.00 * 20,000 = $40,000.

Example 2.

Let’s look at another example of company XYZ Shoe Company. The production data for March 2020 is as below:

• Cost for raw material cost per unit is $35
• Total number of shoe produced is 2,000
• Labor expense is $45 per hour
• Time taken to produce a shoe is 45 minutes
• The total cost of production is $150,000
• Calculate the Fixed Cost of production for XYZ Shoe Company in March 2020.

Solution:

We have,

Total cost of production = $150,000 (A)
Cost for raw material cost per unit = $35 (B)
Labor expense per hour = $45 per hour (C)
Time needed to produce a unit = 45 min = 45 / 60 hours = 0.75 hours (D)
Number of units produced = 2,000 (E)

First, we calculate the variable cost per unit as:

• Variable Cost per Unit = Cost for raw material cost per unit (B) + Labor expense per hour (C) * Time needed to produce a unit (D)
• Variable Cost per Unit = 35 + 45*0.75 = $68.75

Therefore, we can calculate the Fixed Cost of production for XYZ Shoe Company in March 2020 as.

• Fixed Cost of production = Total cost of production (A) - Number of units produced (E) * Variable Cost per Unit.
• Fixed Cost of production = 150,000 – 2000*68.75 = $12,500

Therefore, the Fixed Cost of production for XYZ Shoe Company in March 2020 is $12,500.

Example 3.

XYZ Dolls manufactures children’s toy dolls. To set a fair price for the goods, the firm has to calculate the fixed cost.

XYZ Dolls make a summary of any monthly cost that they have. They split the aggregate list into variable costs and fixed costs. Building rent ($4,000), employee salaries ($100,000), supplies ($3,000) and a website ($300) are their fixed costs.

To measure the cumulative fixed costs, XYZ Dolls adds up all its separate fixed costs:

$4000 + $100,000 + $3000 + $300 = $107,300

Now, XYZ Dolls realizes that they need to make up for $107,300 in their products’ price. To determine the fair price for a doll, they need to calculate the average fixed cost (aka. fixed cost per unit).

For example, assume XYZ Dolls has 8,000 dolls on stock for sales. To get the average fixed cost, they divide $107,300 (the total fixed cost) by 8,000 (the unit number for sale). The average fixed cost, or fixed cost per unit, is 107,000 / 8000 = $13.4.

XYZ Dolls must add that average fixed cost of $13.40 to the sales price to make sure they make up for the fixed cost.

What if XYZ Dolls wants to raise their profit number? Increasing production and producing more dolls is one way to do this. XYZ Dolls company is paying $13.40 on average fixed costs at the production rate of 8,000 dollars a month. The company can increase its production to 10,000 dolls a month. Now, their average fixed cost is only $10.73. In other words, the XYZ Dolls company can make an extra $2.67 in profit per doll sold without changing any other operating expenses.

Final Thoughts

The concept of fixed costs is crucial to consider since it is one of the two main components of the overall production expense, the other being the variable cost. Fundamentally, fixed costs are seen as the sort of fee that, regardless of the company’s level of economic performance, rarely varies.

Nevertheless, it should be noted that fixed costs are not unchanged, and during capacity growth or economic recession, it varies. Theoretically, fixed costs serve as a deterrent to potential competitors in capital-intensive sectors, effectively eliminating the possibility of smaller or younger players competing. Depreciation charges, staff wages, contract leasing, insurance fees, etc., are some of the primary examples of fixed costs.

We can derive the Fixed Cost formula by first multiplying the number of units produced and the variable production cost per unit, then subtracting the result from the overall production cost.

Calculation of your fixed costs is definitely not the most enjoyable part of growing your business. But understanding what they are and when you need to pay for each of them gives you the financial security you need to serve and satisfy your customers.