What are fixed costs?
Fixed costs are expenses that need to be paid irrespective of how much of a particular asset a company uses and whether a business is doing well or not. Take, for instance, a company that has a warehouse with an office and utilities that produces goods. The rent, property taxes and utilities need to be paid every month, so does the salaries, and every business needs insurance. These costs will remain constant, and recur periodically for a given time. Other examples of fixed costs are amortization (this is gradual down payments of intangible assets like a purchased patent) and depreciation (the down payments on tangible assets like production equipment). Although the aforementioned costs vary slightly from month to month – for example; someone may resign from the company, that persons’ salary will not be paid until the position is filled, and utilities that are never the same – these are still fixed costs that will have to be paid regardless of any other aspect of the business and the usage of an asset.
How do fixed costs influence profit margins?
Fixed costs are unlike variable costs that are zero when there is a zero output in the business. When calculating the total cost of a product or service, fixed and variable costs are the two main components that determine profit margins.
For reference, and to understand how fixed costs can influence profit margins, we will use an example where a business sells a product. Assume:
- There is a constant demand for the business to produce a 1.000 units per month.
- The running expenses of the business are $3.000 per month; that amount is divided between the units produced during the month.
- For a month that the business produces a 1.000 units, the fixed cost per unit is $3.00 (= $3.000 / 1.000 units).
- The variable costs like material and shipping are $4.000 for a 1.000 products ($4.000 / 1.000 units = $4.00 variable costs per unit), bringing the cost price to $7.00 per unit (= $3.00 + $4.00).
- Let’s say the selling price is $10.00 per unit – that means the profit is $3.000 for that month or $3.00 per unit.
However, the business can handle 2.000 units without any additional fixed costs, and
- the demand for the product grows to 2.000,
- the fixed cost is still $3.000 per month ($3.000 / 2.000 units = $1.50 fixed costs per unit), and
- the variable cost is $8.000 for 2.000 products ($8.000 / 2.000 units = $4.00 variable costs per unit).
- The total sales of 2.000 products will be $20.000 of which $9.000 will be profit or $4.50 per unit (= $10.00 – ($1.50 + $4.00)), reducing per-unit costs through an increase in production.
This creates economies of scale and is also referred to as a diminishing marginal cost.
Does fixed cost influence the market sentiment?
Yes, high fixed costs are often seen as a barrier to entry into the market for investors and competitors alike, because if sales are poor costs remain high, but when sales soar and fixed costs remain the same, profit is magnified. Companies like airlines and manufacturers usually have high fixed costs. Variable costs fluctuate according to the market, so companies who have a large amount of variable costs may have a more predictable per unit profit margin. Fixed costs vary significantly across industry sectors and should be analysed accordingly. Therefore investors usually define high and low ratios among competitors to keep comparisons meaningful.