Fixed Costs

Fixed costs are business expenses that stay the same in total regardless of how much a firm produces or sells, at least over a given period and range of output. Typical examples are rent, insurance premiums, salaried staff, software licenses, loan interest and the depreciation of equipment. Managers, accountants, lenders and investors track them because they must be paid even when sales are zero.

Fixed costs are the counterpart of variable costs, which rise and fall with output; together the two make up total cost. They are sometimes called overheads or indirect costs, although those accounting labels do not line up exactly with the economic idea. Fixed costs are also distinct from a sunk cost: a fixed cost may still be avoidable in future, for example by ending a lease, while a sunk cost has already been spent and cannot be recovered. In household budgeting the same idea is usually called fixed expenses: regular bills such as rent, insurance and loan repayments that do not change with how much is spent elsewhere.

Think of a gym. Each month it pays the same rent, the same insurance and the same base pay for its manager, whether ten members turn up or a thousand. Those bills are its fixed costs. Towels to wash and electricity for the machines rise with the number of visitors, so they are variable.

The gym's challenge is that fixed bills arrive first and members arrive later. Until enough people sign up, the business loses money every month. Once membership passes a certain point, each new member mainly adds income, because the big bills are already covered. That turning point is the break-even level.

Because fixed costs do not change with volume, the fixed cost carried by each unit falls as output rises. Average fixed cost is simply total fixed cost divided by output. The number of units a firm must sell to cover all its costs is:

• $Q_{BE}$ is the break-even quantity.
• $FC$ is total fixed cost for the period.
• $P$ is the selling price per unit.
• $AVC$ is the average variable cost per unit.

A small software-training firm has fixed costs of $120,000 a year. It charges $50 per course seat, and each seat costs $20 in materials and platform fees. Each seat therefore contributes $30 toward fixed costs, so the firm breaks even at $120,000 ÷ $30 = 4,000 seats. At 2,000 seats each seat carries $60 of fixed cost; at 8,000 seats only $15. This falling cost per unit is one source of economies of scale.

A business with high fixed costs and low variable costs has high operating leverage. Once it passes break-even, extra sales flow almost entirely into profit, but when sales fall, losses grow quickly because the fixed bills remain. Airlines, telecom networks, steel mills, hospitals and software companies tend to have this shape. Operating leverage is related to, but different from, financial leverage, where fixed interest payments on debt play the same amplifying role.

This is why high-fixed-cost industries suffer badly in a recession and why their earnings swing more over the business cycle. It is also why companies try to convert fixed costs into variable ones by outsourcing, renting cloud computing by the hour instead of buying servers, or using contractors. In payments and fintech, start-ups weigh the large fixed cost of licensing, compliance staff and audits against per-transaction fees charged by partners; the contrast is captured in pricing terms such as fixed versus variable charges, monthly recurring costs and non-recurring costs.

In economic theory, fixed costs exist only in the short run, the period in which at least one input, such as plant size, cannot be changed. In the long run every cost is variable, because leases end and machines can be sold or replaced. Short-run decisions should therefore be based on marginal cost: a firm that covers its variable costs should usually keep operating in the short run even if it cannot cover its fixed costs, because shutting down would not remove those fixed bills.

Very large fixed costs shape whole industries. When building the network is expensive but serving one more customer is cheap, as with railways, power grids or water pipes, one firm can often supply a market more cheaply than several, a situation known as natural monopoly. High upfront costs also act as a barrier to entry, which matters for competition policy and for the path to profitability of new businesses.

Financial statements do not label costs as fixed or variable; that split is made in management accounting for budgeting and pricing. Under accrual accounting, a large fixed outlay such as a machine is spread over its useful life through depreciation, and long leases are recognized on the balance sheet under IFRS 16 and US rules.

• Step costs. Many costs are fixed only within a range. Doubling output may require a second warehouse, so fixed costs jump in steps.
• Semi-variable costs. A phone contract with a base fee plus usage charges is partly fixed and partly variable, and has to be split.
• Allocation. Spreading shared fixed costs across products is an accounting choice and can make a profitable product look unprofitable, or the reverse.

• OpenStax, Principles of Economics 3e: Costs in the Short Run