Fixed Costs: Definition, Formula & Examples
Understanding an organization’s cost structure is essential for management to make appropriate investments. In this lesson, you’ll learn the definition of fixed costs and why understanding fixed costs is an important part of financial management.
Fixed Costs
All business costs can be classified as either variable costs or fixed costs. Fixed costs are those costs that do not change based on production levels, while variable costs increase or decrease based on production.
Fixed costs can be assets like buildings and equipment. For example, a beverage company that bottles water is going to need a physical building and an assembly line that includes specialized equipment. If we assume the building and equipment are leased, there is a monthly payment for each of them. The company is responsible for paying 100% of the monthly payments, whether they produce one case of bottled water or 10,000 cases of bottled water.
It is important to note that fixed costs are not always the same. Like the price of anything, they can change – sometimes unpredictably and sometimes on a regular schedule, but they do so based on some other factor, not the level of production. For example, if a lease contract is being renegotiated and a $10,000 per month lease payment is increased to $10,500 per month, fixed costs have risen, but not because of production levels.
Formula for Fixed Costs
As mentioned above, fixed costs are one part of the total cost formula. The formula used to calculate costs is FC + VC(Q) = TC, where FC is fixed costs, VC is variable costs, Q is quantity, and TC is total cost.
It is important to understand that variable costs, as opposed to fixed costs, are those costs that change based on the amount of product being produced. For example, our bottled water company has a variable cost in bottles. The more bottled water they produce, the higher their cost associated with bottles will be.
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