If you're running a business, you most likely have fixed costs. How? Imagine that you run a bakery where you make 500 pieces of cake each week. You realize that business is getting unusually busy, so you buy more flour and increase the pieces of cake to 600 each week. In the scenario we have just described, the cost of flour changed since you increased the amount of flour used. However, notice that you did not increase the number of ovens or the size of the bakery. That's because they are fixed costs, and you didn't have to change them when you increased the quantity of cakes baked. Let's dive right into the topic of fixed costs to learn more. We will calculate fixed costs using the fixed cost formula and use examples of different fixed cost types to understand this concept better. Read on!
Fixed Costs Definition
Fixed costs are the costs that do not change when the quantity of output changes, and they only go away when the business fails or closes down.
Fixed costs are the costs that do not change when the quantity of output changes, and they only go away when the business fails or closes down.
Now that you know the definition, let's explain it with an example.
A shoemaker pays $500 to acquire a shoe-making machine. He then pays $40 or $50 for leather to make shoes, depending on the level of demand each week.
From the above example, the $500 paid to acquire the shoe-making machine is a fixed cost because it does not change regardless of the quantity of shoes the shoemaker wants to make.
Fixed Costs Economics
To better understand fixed costs in economics, a series of related concepts must also be explained. Just as a refresher, fixed costs are those costs that do not change with output. So, what are the costs that do change when output changes? They are variable costs!
Variable costs are costs that change when the quantity of output changes.
You must be wondering why we brought variable costs into this when it's about fixed costs. It's because variable costs combine with fixed costs to make total costs. Therefore, each firm needs to consider both types of costs to get an overall picture of how much it is spending on production.
Total costs are the overall economic production cost and are a combination of variable costs and fixed costs.
All the costs discussed fall under the umbrella of production costs, which refer to the costs a business incurs to employ the factors of production for its business processes.
Production costs are the costs a business incurs to employ production factors for its business processes.
It is important to note that fixed costs often only exist in the short run, and in the long run, all costs can change.
Now, let's see how all these fit in an example.
Gail rented a shop for $700 for her cake business. She also spends $100 a week on employees and cake ingredients to make 50 pieces of cake each week. If Gail wants to increase the quantity of cake her business bakes, she will only have to spend more on employees and cake ingredients. She will not have to spend more on rent.
In the above example, Gail's fixed cost is $700, whereas her variable cost is $100.
Note that Gail's fixed cost will not change even if she decides not to bake any cake at all.
Fixed Costs Formula
For the fixed costs formula, we simply subtract variable costs from the total cost. Mathematically, we can write this as:
\(FC=TC-VC\)
Where FC represents fixed costs, TC represents total costs, and VC represents variable costs.
Let's try an example now.
With a total cost of $300 and a variable cost of $250, what is the fixed cost?
Solution:
Using
\(FC=TC-VC\)
We have
\(FC=$300-$250\)
\(FC=$50\)
Read our article on Production Costs to learn more!
Fixed Costs Curve
We can show fixed costs on the production costs graph of a firm. This graph is plotted with cost on the vertical axis and quantity of output on the horizontal axis. Because fixed costs do not change even when the quantity of output changes, it is a flat horizontal line on the graph. Figure 1 illustrates this.
Fig. 1 - Fixed Costs Curve
As shown in Figure 1, fixed costs remain the same regardless of quantity produced, whereas variable costs increase as the quantity produced increases. This causes the total costs to increase at the rate at which the variable costs increase.
Read our article on Sunk Costs to learn about another type of cost.
How to calculate fixed costs?
The best way to learn how to calculate fixed costs it to work on an example
If a firm has a total cost of $400 and a variable cost of $300, what is the fixed cost of the firm?
Solution:
Using
\(FC=TC-VC\)
We have
\(FC=$400-$300\)
\(FC=$100\)
Want to know how a firm makes profits after incurring all these costs? Read our article on Revenue vs Profit.
Fixed Costs Examples
Examples of fixed costs include rent, salaries, insurance and loan payments.
Rent
Rent is a fixed cost that businesses must pay regardless of how much they produce or sell. For example, a retail store that pays $5,000 monthly rent will have to pay that amount whether they sell $10,000 or $100,000 worth of products monthly.
Salaries
The amount of money a business pays its employees each month is typically fixed and does not change based on production or sales. For instance, if a business has salaried employees who earn $4,000 per month, they will be paid that amount even if the business experiences a slow month in terms of production.
Insurance
For example, a business that pays $1,000 monthly for liability insurance will have to pay that amount regardless of how much they produce or sell. The insurance coverage amount may change based on the business's needs, but the premium amount will remain fixed.
Fixed Costs - Key takeaways
- Fixed costs are the costs that do not change when the quantity of output changes, and they only go away when the business fails or closes down.
- Variable costs are costs that change when the quantity of output changes.
- Total cost is the overall economic production cost and is a combination of variable costs and fixed costs.
- The formula for fixed cost is \(FC=TC-VC\)
- Average costs divide the cost by the quantity of output.
- Examples of fixed costs include rent, salaries, insurance and loan payments.
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