There are many techniques for making your business more profitable. For example, there are some handy formulas every business owner should know to figure out monthly revenue and expenses. Today we’ll look at how to calculate fixed cost.
To be a successful small business owner, you must pay close attention to your company’s financial metrics. Your income statement should serve as a blueprint for finding ways to make your business more profitable.
There will be some expenses you’ll have more control over, like variable costs. You’ll be able to quickly cut down on these costs to increase profitability. Fixed costs, on the other hand, are more stable, and you often have less control over them. For example, you’ll always be responsible for paying expenses like rent, utilities, and licenses.
In this guide, we’ll talk about fixed costs and how you can calculate them. We’ll highlight the differences between fixed costs and variable costs and even give you a few more financial formulas to take your business to the next level.
What Are Fixed Costs?
Fixed costs are those that can’t be changed regardless of your business’s performance. Your company’s total fixed costs will be independent of your production level or sales volume.
Also known as “indirect costs” or “overhead costs,” fixed costs are the critical expenses that keep your business afloat. These expenses can’t be changed in the short-term, so if you’re looking for ways to make your business more profitable quickly, you should look elsewhere.
Fixed costs will stay relatively the same, whether your company is doing extremely well or enduring hard times. As production or sales fluctuate, fixed costs remain stable. Think of them as what you’re required to pay, even if you sell zero products or services.
Examples of Fixed Costs
Fixed costs can include recurring expenditures like your monthly rent, utility bills, and employee salaries. Here are a few examples of fixed costs to give you a better idea.
- Property rent: Your rent will be the same from month to month unless you decide to switch your offices.
- Utility bills: For the most part, electricity, website hosting, internet, and telephone bills will fluctuate very little throughout the year. However, some utility costs may depend on the level of production and can be classified as a variable cost — we’ll touch more on that in the next section.
- Payroll: The money you pay your employees is stable unless you are giving raises or commissions or adding more employees to your team.
- Insurance: Insurance costs like healthcare for your employees or property insurance will be fairly constant.
- Interest on loans: Interest on business loans will be relatively stable unless you pull out more loans or make a substantial payment on your current loans.
- Licenses and permits: The licenses and permits you need to do business are a fixed fee and likely won’t be affected by your production volume.
- Property taxes: Your property taxes on the buildings, equipment, and vehicles you purchase is a fixed cost.
- Manufacturing equipment: The equipment you purchase to do business, will likely come with standard monthly payments.
- Vehicle leases: If your company leases vehicles, these will come with monthly payments throughout the duration of the lease.
Now that you know that fixed costs are what you’re required to pay regardless of sales or production, what are the costs that fluctuate as your business grows? These are known as variable costs.
Fixed Costs vs. Variable Costs
Variable costs are expenses that change as production increases or decreases. If a company produces more products or services, then variable costs will rise. If a company scales back production, then variable costs will drop.
While fixed costs won’t fluctuate if production levels increase, variable costs are directly affected by a company’s output. This is the clear distinction between these two different types of costs.
If a company makes zero sales for a period of time, then total variable costs will also be zero. But if sales are through the roof, variable costs will rise drastically. What your company should aim for are low variable costs that enable larger margins so your business can be more profitable.
Examples of Variable Costs
Examples of variable costs can include the raw materials required to produce each product, sales commissions for each sale made, or shipping fees for each unit. Here are a few examples of variable costs.
- Raw materials: You’ll need raw materials to create every product you sell. The more products you sell, the more raw materials needed to create each product.
- Labor: While employee salaries are relatively stable and can be considered a fixed cost, you’ll need to hire more workers if you want to scale your production levels. It will require more hands on deck to create more products or provide more services, thus some labor can be considered a variable cost.
- Sales commissions: If you offer your employees sales commissions, then you’ll need to pay a small percentage of every closed deal.
- Shipping: If you sell more products, then you’ll need to pay more shipping fees to send your goods to customers.
- Utility bills: Some utility bills may be affected by your production level. For example, if you produce thousands of products, your electricity bill will be much higher than if you only created five products.
Now that you know the difference between fixed costs and variable costs, let’s look at how you can calculate your total fixed costs.
How to Calculate Fixed Cost
Calculating your fixed costs is relatively straightforward. One way is to simply tally all of your fixed costs, add them up, and you have your total fixed costs. You can also use a simple formula to calculate your fixed costs.
First, add up all of your production costs. Make sure to be clear about which costs are fixed and which ones are variable. Take your total cost of production and subtract your variable costs multiplied by the number of units you produced. This will give you your total fixed cost.
You can use this fixed cost formula to help.
Fixed costs = Total production costs — (Variable cost per unit * Number of units produced)
Let’s use a real-world example. Imagine you own a food truck that sells tacos. You’ll have a range of fixed costs and variable costs that you’re required to pay each month.
If you add up everything you spent over the course of the month, it equals $4,000 in total costs. Then factor in all the tacos you sold throughout the month — 1,000 tacos. Each taco costs $3 to make when you consider what you spend on taco meat, shells, and vegetables. Therefore, your variable cost per unit is $3.
Plug these numbers into the following formula:
$4,000 total production costs — ($3 * 1,000 tacos) = $1,000 fixed cost
So your monthly fixed costs in this scenario are $1,000. These costs are likely attributed to your food truck monthly payment, auto insurance, legal permits, and vehicle fuel. No matter how many tacos you sell every month, you’ll still be required to pay $1,000.
What Is Average Fixed Cost?
Instead of looking at your fixed costs as a whole, you can break your fixed costs down on a more granular level. Your average fixed cost can be used to see the level of fixed costs you’re required to pay for each unit you produce.
This will help you determine how much your business must pay for every unit before you factor in your variable costs for each unit produced.
Average fixed cost = Total fixed cost / Total number of units produced
Think about if you run an auto shop that primarily does oil changes. You’ll need to pay for the rent of your garage, utility bills to keep the lights on, and employee salaries. The more oil changes you’re able to do, the less your average fixed costs will be.
If your monthly fixed costs are $5,000 and you’re able to do 1,000 oil changes, then your average fixed cost per unit is $5 per oil change. If you’re able to increase oil changes up to 2,000, your average fixed cost per unit will be cut in half to $2.50.
It’s in your best interest to spread out your fixed costs by producing more units or serving more customers. You should also be aware of how many units you need to sell if you want to break even and become profitable.
What Is the Break-Even Point?
Knowing your fixed costs and variable costs can help you calculate your company’s break-even point. The break-even point is the number of units you need to sell to make your business profitable.
If you’re starting a new business, then the break-even point will help you determine the viability of the endeavor. If you already have your business up and running, the break-even point will help you find areas to improve your business and profitability.
For example, if the number of units required to become profitable is very high, you can look into ways to increase sales, reduce your variable costs per unit, or find ways to cut down on fixed costs.
You can use a break-even analysis to figure out at what point you’ll become profitable.
Break-even point = Fixed costs / (Price — Variable costs per unit)
Let’s say you started a small coffee shop that specializes in gourmet roasted coffee beans. Your fixed costs are around $1,800 per month, which includes your building lease, utility bills, and coffee roaster loan payment.
Your variable unit costs are $1 which includes paper coffee cups, coffee beans, and milk for spinning up lattes. You decide to sell cups of gourmet coffee for $4 per cup.
So how many cups will you need to sell per month to be profitable? Let’s plug it into the formula.
$1,800 fixed costs / ($4.00 price per cup — $1 variable costs) = 600 cups of coffee
You’ll need to sell 600 cups of coffee every month if you want your business to be profitable. If you divide that by roughly 30 days in a month, you’ll need to sell 20 cups of coffee per day in order to break-even.
Know Your Numbers
It might not be fun, but calculating your fixed costs on a regular basis will benefit your business in the long run. Having a finger on the pulse of your business metrics will be crucial to happily serving your customers for years to come.
Although you may not be able to influence your fixed costs in the near-term, it’s important to distinguish between your fixed costs and variable costs. It’s also helpful to understand that in the long term you can try reducing your fixed costs, like for instance shopping around for cheaper insurance plans or switching the software your company uses.