What is the Meaning of Fixed Expenses?

With increase in production, the total fixed cost remains constant, whereas the fixed cost per unit decreases. On the other hand, the total variable cost increases with increase in production, but the variable cost per unit remains constant.

Fixed costs are those costs that do not change in the short run, irrespective of the quantity of goods produced. They do not vary with the change in output or level of production. With the increase in production, the fixed cost per unit reduces and vice versa. You might have come across fixed costs in many instances in day-to-day life.

Let's start with a household example. During a month, you incur various types of expenses―energy and telephone bills, groceries, utilities, car maintenance, fuel, house rent, etc.

Now, if you try to classify these expenses, you'll find that some expenses depend on use or consumption, while some remain independent of use or consumption. Electricity, telephone, fuel, etc., varies according to use. Hence, they're variable expenses.

On the other hand, if you're living in a rented place, and you've been out on a business tour for a few days, you still need to pay the rent, in spite of not using the place for a few days. Thus, the monthly rent that you pay is a fixed cost.

However, there can be a mixture of fixed and variable expense. For example, your phone expenses might be inclusive of some fixed cost element, irrespective of its use. That part is fixed cost, and the remaining which depends on the usage is variable cost. Such costs are known as 'semi-variable' costs.

Similarly, for business organizations, it is very important to classify the costs into fixed and variable costs. Let's see why, with the help of an example.

Company X has expansion plans. It estimates that the initial setup will require buying and installing heavy machinery. These expenses are fixed costs, since they have to be incurred, irrespective of whether goods or products are produced or not. After market research, it is revealed that the recovery of fixed costs will require a long tenure.

Considering the tenure for recovery of fixed costs, the management decides to drop their expansion plans. Initially, huge fixed costs are incurred, hence any business will take time to recover it; however, comparison of cost and benefit makes it easy for the management to take such decisions.

Factory/Office rent, deposits, machinery costs, depreciation, insurance, annual maintenance contract charges, salaries to office staff, etc., are all examples of fixed expenses. You can save your costs by controlling your variable costs. However, it is difficult to put a budgetary constraint on fixed costs, though they can be controlled, too.

Given are the formulas for determining fixed cost.

Total Costs = Fixed Cost + Variable Cost

Fixed Cost per unit = Total Fixed Cost / Quantity Produced

Example
To produce 1 unit of a product, the total cost incurred is 50,000, whereas to produce 2 units of a product, the total cost is 60,000. What is the fixed cost incurred?

Solution
Let 'x' represent total fixed cost, and 'y' represent the variable cost per unit. Thus, we form the following two equations on the basis of information furnished to us:

x + y = 50,000
x + 2y = 60,000

Solving the two equations, we get:
y = 10,000

Thus, x = 40,000
Fixed cost is 40,000 USD.

The classification of fixed and variable cost is of high relevance in the field of costs and works accounting. Cost accountants use this classification for analyzing budgetary constraints.