Definition of Fixed Cost
A fixed cost is one that does not change in total within a reasonable range of activity. Since the fixed cost remains constant in total, the fixed cost per unit of activity decreases when the volume increases, and the fixed cost per unit of activity increases when the volume decreases.
Examples of Fixed Costs
Assume the rent for a production facility is a fixed cost of $120,000 per year and there are normally 30,000 machine hours of good output during a year. At that volume of activity, the rent is $4 ($120,000/30,000) per machine hour. If there are 40,000 machine hours during a year, the rent will be $3 ($120,000/40,000) per machine hour. (Of course, if there is a need to double the number of machine hours, the total amount of rent will likely increase to accommodate this large increase in activity. This is why accountants say a cost is fixed only within a reasonable or relevant range of activity.)
Many manufacturing overhead costs are fixed and the amounts occur in large increments. Additional examples include depreciation on a company-owned factory, depreciation on machinery and equipment, salaries and benefits of manufacturing supervisors, factory administration costs, etc.
One of the challenges regarding fixed manufacturing overhead costs is the allocation or assigning of the fixed costs to the individual units of product (which likely vary in size and complexity). The allocation is referred to as absorption costing, which is required by U.S. accounting and income tax rules for valuing a manufacturer’s inventories and its cost of goods sold.
It is important to remember that while the fixed overhead is assigned to products on the basis of machine hour usage, this is not how the fixed costs behave or occur. For instance, the cost of the production facilities’ rent might be assigned to the products at the rate of $4 per machine hour, but the rent actually occurs at the rate of $10,000 per month regardless of the number of machine hours.
