Is Depreciation a Fixed Cost for a Business?
Clarify the nature of depreciation as a business expense. Discover why this accounting allocation of a past asset purchase is generally considered a fixed cost.
Businesses face various costs as they operate, and understanding how these expenses are classified helps in financial planning and decision-making. A common question arises regarding the nature of depreciation: whether it falls under the category of a fixed cost or a variable cost. This classification can be confusing because depreciation relates to assets used in production but does not directly fluctuate with output.
Understanding Fixed and Variable Costs
Fixed costs are business expenses that do not change in total, regardless of the level of goods or services produced within a relevant range and time period. Examples include the monthly rent for a factory building or annual insurance premiums for business operations. These costs are incurred even if production ceases, as they are independent of output volume.
Variable costs, conversely, are expenses that change in direct proportion to the volume of goods or services produced. For instance, the cost of raw materials used to manufacture a product increases as more units are made. Wages paid directly to production line workers rise with increased output, as does the cost of shipping more finished goods to customers.
What is Depreciation?
Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life. Instead of expensing the entire purchase price of a large asset, such as machinery or a vehicle, businesses spread this cost over the years the asset is expected to generate revenue. This process aims to match the expense of using the asset with the revenues it helps produce, providing a more accurate picture of profitability over time.
The purpose of depreciation is to reflect the gradual wear and tear, obsolescence, or consumption of an asset’s economic benefits. It is considered a non-cash expense, meaning that while it is recorded on the income statement, no actual cash outflow occurs when the depreciation entry is made. The cash outflow for the asset happened when it was initially purchased, which was a capital expenditure.
Is Depreciation a Fixed Cost?
Depreciation is considered a fixed cost for a business. The decision to acquire a long-term asset, such as equipment or a building, represents a past capital expenditure. The subsequent depreciation expense is the systematic allocation of that initial cost over the asset’s useful life, regardless of how much the asset is used in a given period.
The amount of depreciation expense remains constant each accounting period, especially when using methods like straight-line depreciation. Even with methods that link depreciation to usage, such as the units of production method, the underlying cost of the asset itself is a fixed amount. Therefore, the expense charged to operations each period represents a portion of a fixed investment, making depreciation a fixed cost.