How To Calculate Fixed Cost in 3 Steps (With Examples)
All companies encounter costs during the act of doing business. These expenses can be categorized into fixed costs or variable costs. Businesses need to understand how to calculate fixed costs to appropriately price goods or services.
In this article, you will learn about fixed cost, how to calculate total fixed cost and average fixed cost, as well as see fixed cost examples.
What is fixed cost?
Fixed cost is any business expense that does not change based on production or sales. Fixed costs are also sometimes called indirect costs or overhead. Fixed costs cannot be changed by the business to decrease expenses. Instead, they are usually set by an outside entity like a landlord or bank. Rent, insurance and labor are all examples of fixed costs. Variable costs are business expenses that can change based on production or sales. Merchandise materials and utilities are examples of variable costs.
Total fixed cost, or the overall expense of all individual fixed costs, is usually calculated over a short period, for example, a month or six months. While the expenses associated with fixed cost won't change based on sales, they may go up or down depending on other factors. For example, your landlord may increase the rent on your office. This will increase your fixed costs, but this increase is not related to production or sales. Thus, it is recommended to calculate only your fixed costs in the short term in case these costs fluctuate.
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How to calculate fixed cost
You can find your fixed costs using two simple methods. The first way to calculate fixed cost is a simple formula:
Fixed costs = Total cost of production - (Variable cost per unit x Number of units produced)
First, add up all production costs. Note which of those costs are fixed and which ones are variable. Take your total cost of production and subtract the variable cost of each unit multiplied by the number of units you produced. This will give you your total fixed cost.
The second method of calculating fixed cost is to tally all of your fixed costs and add them up. To calculate fixed cost using the tally method, follow the steps below:
1. List all costs
Begin by listing every monthly cost your business has. To help you, look back at receipts, budgets and bank account transactions. Expenses paid annually should be divided by 12 and accounted for. List every expense and the cost of that expense per month, ideally in a spreadsheet.
Example: ABC Dolls makes toy dolls for children. The business needs to calculate its fixed cost to set a reasonable price for its product. They make a list of every expense they have per month.
2. Separate fixed costs from variable costs
Since you are only interested in the fixed costs, itemize the list of expenses by fixed costs (those that do not change based on production or sales) and variable costs (those that are directly impacted by production or sales).
Example: ABC Dolls separates its overall list into fixed costs and variable costs. Their fixed costs include building rent ($3,000), employee wages ($80,000), equipment ($2,000) and a website ($200).
3. Add fixed costs
Add together all the individual monthly figures in the fixed cost list. That number represents your monthly total fixed cost.
Example: ABC Dolls adds up all its individual fixed costs to calculate its total fixed costs:
$3,000 + $80,000 + $2,000 + 200 = $85,200
Now, ABC Dolls knows that they need to account for $85,200 per month in the price of their dolls. To determine the right price per doll, ABC Dolls needs to calculate the average fixed cost.
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What is average fixed cost?
Average fixed cost, also called fixed cost per unit, assigns a cost to each piece of merchandise to account for all the fixed costs it takes to run the business. Average fixed cost helps businesses determine a price point for their merchandise. It is important to know the average fixed cost because if it is not included in the price of the business's product, the business will not make a profit.
Calculate fixed cost per unit by dividing the total fixed cost by the number of units for sale.
Example: ABC Dolls has 6,000 dolls available for customer purchase. To determine the average fixed cost, divide $85,200 (the total fixed cost) by 6,000 (the number of units for sale). The average fixed cost, or fixed cost per unit, is $14.20. ABC Dolls must add $14.20 to the sales price to make sure they are accounting for the fixed cost.
ABC Dolls wants to increase its profits. One way to do this is to increase production and make more dolls. At the current production rate of 6,000 dolls per month, ABC Dolls spends $14.20 on average fixed cost. The company can expand its production to 8,000 dolls per month. Now, their average fixed cost is $10.65. The company will make an additional $3.55 in profit per doll sold without adjusting any spending.
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Examples of fixed costs
Many businesses have these fixed costs:
Labor is the human effort it takes to create a product or service. Labor costs are usually labeled as payroll.
Permits or licenses
Permits and licenses are necessary for some businesses to operate legally. Whether or not your company requires a permit, the type of permit and the overall cost of the permit depends on what your company makes or does. For example, restaurants or bars that serve alcohol must have a liquor license.
Maintenance covers a wide array of costs. It may refer to cleaning supplies, machinery repair expenses or annual tune-ups for vehicles.
Rent or mortgage
This is the cost of the building or warehouse out of which your business operates.
Most companies have an online presence. Website hosting, web design and website content updates are all fixed costs.
In addition to a website, your company may allow for online purchasing. If so, e-commerce fees might apply to your business.
Examples of equipment might be forklifts, computers or manufacturing equipment specific to your product.
Your company may provide cars to employees or service trucks for house calls. Some companies may even own or lease boats or planes.
Many businesses take out loans. Monthly loan payments are a fixed cost.
Insurance can include employee health insurance, vehicle insurance and building insurance.
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