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Fixed Costs


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Do you know what fixed costs are and how they impact on the method you use to set your prices?  So what are they?

The simplest and most common definition is that they are costs that do not vary in total during a period even though the volume of goods manufactured or sold may be higher or lower than anticipated.

Generally it is difficult to attribute or allocate these costs directly to your products or services as there is no direct link between the expense and the product.  

Most small businesses will allocate their fixed costs on a percentage basis.  

Larger organisations are more likely to use a cost accounting methodology (like activity based costing) to allocate fixed costs.  

But these methods take a considerable amount of time and effort to set up and maintain.

And as a result, most micro businesses are prepared to forgo the additional accuracy and settle for a less costly method of allocating these costs.

For a manufacturing business the costs that are fixed in the medium to long term would include things like:

  • Factory rent,
  • Administrative salaries,
  • Machine hire or lease costs,
  • Utilities for the factory and offices, and
  • Depreciation on assets.

The fixed costs for a retail business might include things like:

  • The cost or leasing a shop-front,
  • Utilities,
  • Staff salaries, and
  • Utilities or center management costs.

An online business might include any or all of the costs above, but might also include costs like:

  • software development costs
  • leases for computing equipment, software or apps

Why are Fixed Costs Important?

Fixed costs are costs that you will have to pay whether you are producing goods for sale or not and cannot generally traced directly back to units of product.

When you are calculating your unit cost for your product a proportion of your fixed costs will be attributed to each unit. That proportion will vary depending on the activity level of your business.

As an example let us assume that your fixed costs are $100,000 per year.

If your activity level is 100,000, $1.00 of fixed will be attributed to each unit of product. However, if you activity level is 50,000, $2.00 of fixed cost will be attributed to each unit of product.

If your variable cost for each unit is high, the change in the allocation of fixed costs might not make a significant difference to your costing and pricing decisions, but what if the variable cost per unit is $0.50? By reducing the activity from 100,000 to 50,000, you have decreased your total costs by $25,000 (50,000 x $0.50) but the unit cost for each unit of product has increased by 66.67%.

If you are operating in a highly competitive market or your customers are price sensitive, you just might have a problem.

 

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