Home Economics What is meant by “Fixed Costs”? Definition and Case Studies

What is meant by “Fixed Costs”? Definition and Case Studies

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A fixed cost is a cost that does not change with an increase or decrease in the measure of goods or services delivered or sold. Fixed costs are expenses that must be paid by an organization, autonomous of any business action. It is one of the two parts of the aggregate cost of maintaining a business, alongside factor cost.

Analyzing ‘Fixed Costs’

A fixed cost is a working expense of a business that can’t be stayed away from paying little respect to the level of creation. Fixed costs are utilized as a part of a breakeven analysis to decide evaluating and the level of creation and deals under which an organization produces neither profit nor misfortune. Fixed costs and variable costs shape the aggregate cost structure of an organization, which assumes an essential part in guaranteeing its profitability.

 

Cases of Fixed Costs

Bookkeepers perform deep analysis of various expenses to decide if they are variable or fixed. Higher fixed costs in the aggregate cost structure of an organization expect it to accomplish more elevated amounts of revenues to make back the initial investment. Fixed costs must be brought about routinely, and they tend to demonstrate little changes from period to period.

Cases of fixed costs incorporate insurance, intrigue expense, property charges, utility expenses and devaluation of advantages. Additionally, if an organization pays yearly pay rates to its representatives independent of the quantity of hours worked, such pay rates must be considered fixed costs. An organization’s rent on a building is another basic case of fixed costs, which can retain critically subsidizes particularly for retail organizations that lease their store premises.

Recommended Reading: Price Floor; Definition, Implications And Examples

Fixed Costs and Economies of Scale

A business must bring about factor and fixed costs to create a given measure of goods. Variable costs per thing remain moderately level, and the aggregate variable costs change proportionately to the quantity of item things created. Fixed costs per thing decrease with increases underway. In this manner, an organization can accomplish economies of scale when it delivers enough goods to spread a similar measure of fixed costs over a bigger number of units created and sold.

For instance, a $100,000 rent spread out more than 100,000 gadgets implies that every gadget conveys with it $1 in fixed costs. On the off chance that the organization produces 200,000 gadgets, the fixed cost per unit drops to 50 pennies.

Organizations with expansive fixed costs and unaltered variable costs in their generation procedure tend to have the best measure of working influence. This implies after an organization accomplishes the breakeven point, all else meet any further increases in a deal will deliver higher profits in the extent to deals increase for an organization up to a point where fixed costs per unit sold wind up noticeably immaterial. On the other hand, decreases in deals volume can create lopsidedly higher decreases in profits.

A case of organizations with high fixed cost part are service organizations, which need to make expansive interests in infrastructure and have in this way vast devaluation expenses with moderately stable variable costs per unit of power created.

 

Fixed costs; a deep hole! Case study

A firm with fixed costs starts each month standing at the bottom of a deep financial hole. The depth of that “money pit” is equal to the dollar value of all the payments that the firm is legally obligated to make even if it is producing nothing. These fixed costs include contractually guaranteed salaries, interest payments on loans, and equipment rental fees that are locked-in by long-term contracts.

As the firm stands at the bottom of this fixed-cost financial hole and stares upward looking for a way out, it has to ask itself the following question: Will producing output make the hole even deeper?

Generating private cash flows to counteract fixed costs

Naturally, the firm hopes that producing output will generate positive cash flows that will offset its fixed costs and start filling in the hole. If those positive flows are large enough, they may completely offset the firm’s fixed costs and fill up the hole, thereby allowing the firm to break even. And if they are just a bit larger, they will not only fill up the hole but also accumulate a nice little pile of profits above ground.

On Ground realities and fixed costs

But those are just the firm’s hopes. The firm’s reality may be quite unpleasant. In particular, the firm may be facing a situation in which producing output would make its financial situation worse rather than better. As explained in this chapter, if the price of the firm’s output falls too low, then producing output will yield cash flows that are negative rather than positive because revenues will be less than variable costs. If that happens, producing output will lose money for the firm so that the firm would be better off shutting down production rather than producing output. By shutting down, it will lose only its fixed costs. By shutting down, its financial hole won’t get even deeper.

Unaccomplished Fixed costs ultimately lead to shutdown

A crucial thing to understand, however, is that the low prices that cause firms to shut down production are often temporary—so that shutdowns are also often temporary. Just because a firm shuts down at a given moment to prevent its financial hole from getting any deeper does not mean that the firm will go out of business forever. To the contrary, many industries are characterized by firms that regularly switch production on and off depending upon the market price they can get for their output and, consequently, whether producing output will generate positive or negative cash flows.

Various cases of Limiting Fixed costs

  • Oil production is a good example. Different wells have different variable production costs. If the price of oil drops below a given well’s variable costs, then it would be better to halt production on that well and just lose the value of its fixed costs rather than pumping oil whose variable costs exceed the revenue that it generates when sold.
  • Seasonal resorts are another good example of turning production on and off depending on the price. The demand for hotel rooms near ski resorts in New Hampshire, for instance, is much higher during the winter ski season than it is during the summer.
    As a result, the market price of hotel rooms falls so low during the summer that many inns and resorts close during the warmer months. They have all sorts of fixed costs, but it makes more sense for them to shut down rather than remain open, because operating in the summer would cost more in variable costs than it would generate in revenues. Better to lose only their fixed costs.
  • Numerous other examples of temporary shutdowns occur during recessions, the occasional economy-wide economic slowdowns during which demand declines for nearly all goods and services. The 2007–2009 recession in the United States, for instance, saw many manufacturing companies temporarily shut down and mothball their production facilities.
  • The recession witnessed the mothballing of electric generating plants, factories that make fiber optic cable, automobile factories, chemical plants, textile mills, and even the plant in McIntosh, Alabama, that makes the artificial sweetener Splenda. Many other firms also shut down production to wait out the recession—so many, in fact, that there was a mini-boom for consulting firms that specialized in helping firms mothball their factories (the main problem being how to properly store idle machinery so that it will work again when it is eventually brought back into service).
  • Firms that mothball factories or equipment during a recession do so expecting to eventually turn them back on. But the lengths of recessions vary, as do the specific circumstances of individual firms. So while many firms shut down in the short run with the expectation of reopening as soon as their particular business conditions improve, sometimes their business conditions do not improve. Sometimes the only way to terminate fixed costs is to terminate the firm.

In short, the only solution is to plan your business in a way that fixed costs are easily met.

 

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