Fixed Costs

What it is:

Fixed costs are costs that do not change when the quantity of output changes. Unlike variable costs, which change with the amount of output, fixed costs are not zero when production is zero. 

How it works/Example:

Some examples of fixed costs include rent, insurance premiums, or loan payments. Fixed costs can create economies of scale, which are reductions in per-unit costs through an increase in production volume. This idea is also referred to as diminishing marginal cost. 

For example, let's assume it costs Company XYZ $1,000,000 to produce 1,000,000 widgets per year ($1 per widget). This $1,000,000 cost includes $500,000 of administrative, insurance, and marketing expenses, which are generally fixed. If Company XYZ decides to produce 2,000,000 widgets next year, its total production costs may only rise to $1,500,000 ($0.75 per widget) because it can spread its fixed costs over more units. Although Company XYZ's total costs increase from $1,000,000 to $1,500,000, each widget becomes less expensive to produce and therefore more profitable.

Some fixed costs change in a stepwise manner as output changes and therefore may not be totally fixed. Also note that many cost items have both fixed and variable components. For example, management salaries typically do not vary with the number of units produced. However, if production falls dramatically or reaches zero, layoffs may occur. Economically, all costs are variable in the end.

Why it Matters:

A company with a relatively large amount of variable costs may exhibit more predictable per-unit profit margins than a company with a relatively large amount of fixed costs. This means that if a firm has a large amount of fixed costs, profit margins can really get squeezed when sales fall, which adds a level of risk to the stocks of these companies. Conversely, the same high-fixed-costs company will experience magnification of profits because any revenue increases are applied across a constant cost level. Thus, as you can see in the example, fixed costs are an important part of profit projections and the calculation of break-even points for a business or project.

In some cases, high fixed costs discourage new competitors from entering a market and/or help eliminate smaller competitors (that is, fixed costs can be a barrier to entry). Typical fixed costs differ widely among industries, and capital-intensive businesses obv more long-term fixed costs than other businesses. Airlines, auto manufacturers, and drilling operations usually have high fixed costs. Businesses focused on services like website design, insurance, or tax preparation generally depend on labor rather than physical assets and are thus don't have as many fixed costs. This is why comparison of fixed costs is generally most meaningful among companies within the same industry, and investors should define "high" or "low" ratios within this context.

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