Understanding Fixed Costs and Their Importance in Business

In the business world, understanding the concepts of fixed costs and variable costs is fundamental for any business owner. 

Fixed costs are one of the key elements in managing a business's finances. This article will explain what fixed costs are, how they differ from variable costs, and provide examples to help you better understand the concept.

What Are Fixed Costs?

Fixed costs are expenses that remain constant and do not change despite fluctuations in production or sales volume. These costs are consistent over time and do not vary in the short term.

In business, fixed costs are often referred to as overhead or indirect costs. They are incurred by companies to operate the business, even though they are not directly related to production processes. Common examples include expenses such as building rent, employee salaries, and insurance premiums.

For instance, if you own a café, the rent for the location and barista salaries must be paid monthly, regardless of the number of visitors. 

This is why fixed costs play a crucial role in financial calculations. Understanding fixed costs can also help you budget effectively, forecast expenses, and minimize unnecessary spending.

The Difference Between Fixed Costs and Variable Costs

Source: freepik.com

A company generally has two types of operational costs: fixed costs and variable costs. 

The combination of these two costs results in the total cost. The difference between fixed costs and variable costs lies in the nature of their changes. 

Fixed costs are expenses that remain constant and are paid by the company regardless of any conditions. These costs tend to remain the same and are unaffected by sales. 

Meanwhile, variable costs are expenses incurred by the company that fluctuate based on the volume of production or business activities. The amount of variable costs can vary depending on the company's circumstances.

Key distinctions between fixed and variable costs can be observed in the following aspects:

1. Time Frame

Fixed costs are usually incurred over longer periods, such as monthly or annually. In contrast, variable costs are more frequent, occurring daily or weekly.

2. Payment Amount

Fixed costs are generally larger and remain constant, even if the company is not generating profit. Variable costs, on the other hand, are smaller and adjustable based on the company’s financial condition.

3. Relation to Production

Fixed costs are not directly tied to production processes. If production decreases, fixed costs remain unchanged. Variable costs, however, are heavily influenced by production volume.

4. Accounting Reports

Fixed cost reports are typically prepared less frequently, such as monthly or annually. Variable cost reports may be issued daily, weekly, or monthly, depending on product flow.

5. Pricing Strategy

Fixed costs, though significant, are rarely used as a basis for determining product prices. Variable costs, however, are often a key factor in pricing decisions.

Read more: Prevent Financial Report Fraud with This Technology

Examples of Fixed Costs and Variable Costs

To better understand the differences between fixed and variable costs, consider these examples:

1. Fixed Costs:

• Building Rent: Payments for property leases, such as buildings or land, remain constant regardless of company revenue.
• Insurance: Once enrolled in an insurance program, companies are obligated to pay a fixed monthly premium.
• Property Tax: The annual property tax (PBB) amount does not increase as long as the property size remains unchanged.

2. Variable Costs:

• Raw Materials: The cost of raw materials varies with production levels.
• Product Distribution Costs: Expenses for delivering products, such as fuel and driver wages, depend on the quantity of products distributed.
• Sales Commissions: Companies may offer sales commissions to motivate employees, with amounts depending on how much is sold.

How to Calculate Fixed Costs  

After understanding fixed costs, the next important thing to grasp is how to calculate them. There are two simple methods for calculating fixed costs.  

The first method is by using the formula:  

When using this formula, ensure you identify which expenses are fixed costs and which are variable costs from the outset. This will help you input the data into the formula more easily.  

The second method for calculating fixed costs is by summing up all the expenses incurred by the company. You can follow these steps:  

1. List All Expenses

Create a list of the company’s monthly expenses. This can be done by reviewing transaction histories, receipts, budget records, and similar documents.  

2. Separate Fixed Costs and Variable Costs

Once you have all the necessary business records, break them down into details. Separate the data for fixed costs from variable costs.  

3. Add Up the Fixed Costs  

After identifying and separating the fixed and variable costs, the final step is to sum up all the fixed costs. The total amount will represent the company’s monthly fixed costs.  

Read more: What is Cash Flow: A Complete Guide to Cash Flow Reports and How to Create Them

Conclusion

Fixed costs are an essential element that every business owner needs to understand. 

By recognizing the differences between fixed costs and variable costs, you can better manage your finances and improve business profitability. 

ESB is here to help you efficiently manage fixed and operational costs with innovative solutions.

To simplify the management of your culinary business, take advantage of ESB’s solutions like ESB Core and ESB POS Lite. 

With ESB Core, you can manage inventory, stock movements across all branches, and access comprehensive financial reports such as balance sheets, cash flow management, and multi-company integrated reports. 

Enjoy simplified bookkeeping with no monthly fees and the ease of adding new branches. Consult your business needs with us now!