Does Fixed Cost Change and What Causes It?
Uncover how fixed costs are more dynamic than you think. Learn the mechanisms and factors that cause these essential business expenses to shift.
Businesses incur various expenses to operate, and these are often categorized as either fixed or variable costs. While fixed costs are frequently perceived as unchanging, they can indeed shift under specific circumstances. This dynamic nature is important for businesses to understand for effective financial planning and decision-making.
Understanding Fixed Costs
Fixed costs are business expenses that generally remain constant in total, irrespective of the volume of goods or services produced within a specific period and relevant range of activity. They are incurred regularly and must be paid even with little to no production or sales. They are considered indirect costs because they are not directly tied to the production process itself.
Common examples of fixed costs include rent or mortgage payments for premises, property taxes, and insurance premiums, which are often set by contract for a specified period. Salaries of administrative staff, such as office managers or executives, and depreciation of equipment or buildings also fall into this category, as these expenses typically do not fluctuate with daily production levels.
How Fixed Costs Change
While fixed costs are stable within a relevant range, they are not permanently static and can change. One common way fixed costs adjust is through “step costs,” which remain fixed for a given level of activity but then increase or decrease in discrete jumps once a certain threshold of activity is crossed.
For example, a company might need to lease an additional warehouse or open a new production line, which would introduce a new fixed cost for rent and utilities for that space. Expanding operations might require hiring an additional supervisor or management team, increasing fixed salary expenses. Conversely, a reduction in activity below a certain point could lead to a corresponding step-down in costs, such as closing a facility or reducing administrative staff. Fixed costs can also change over the long term due to strategic decisions or shifts in the business model, moving beyond the initial relevant range.
Factors Driving Fixed Cost Changes
Changes in fixed costs are driven by internal business decisions and external market or economic conditions. Internally, business expansion or contraction directly influences fixed costs.
For instance, increasing production capacity might necessitate investing in new machinery, adding to depreciation and maintenance costs. Conversely, downsizing operations could involve selling off assets or consolidating facilities, reducing fixed costs like property taxes and rent. Strategic decisions also play a role, such as investing in new technology, like an enterprise resource planning (ERP) system, incurring substantial software licensing fees and ongoing support contracts. Outsourcing certain functions, while potentially reducing internal fixed salaries, might introduce new fixed contractual payments to external service providers.
Externally, factors like inflation can lead to increased rent or insurance premiums upon contract renewal. Changes in regulations, such as new compliance requirements, may necessitate hiring specialized personnel or acquiring new systems, adding to fixed expenses. Shifts in market conditions, like increased competition, could also compel a business to invest in new marketing campaigns or administrative infrastructure, altering its fixed cost structure.