4. Fixed costs

Fixed costs remain constant within a relevant range of time or activity.

However, fixed costs per unit usually change with changes in the activity base. Insurance costs, rent costs, and salaries of accounting personnel are typical fixed costs.

For example, Friends Company pays property insurance in the amount of $50,000 per year. The insurance premium is a fixed cost that does not vary with the number of produced valves. Regardless of the number of units produced (i.e., 10,000 or 50,000 units), the company will still be assessed $50,000 in property insurance per year. Although the total fixed cost remains the same as the number of valves produced changes, the fixed cost per valve changes. The more valves produced, the less fixed cost per unit. Illustration 5 shows this relationship:

Illustration 5: Fixed cost of property insurance at different production levels

The data from the table above can also be presented in a graph. Illustration 6 demonstrates how the property insurance cost behaves when the total production changes:

Illustration 6: Total fixed cost graph

Note that the property insurance cost line starts at $50,000 and does not change with the increase in the number of units produced. That is because fixed costs remain constant within a relevant range.

Illustration 7 shows how the fixed cost of property insurance behaves on a per-unit basis as production changes:

Illustration 7: Unit fixed cost graph

As you can see from the graph, the per-unit fixed cost decreases as the number of valves produced increases. This happens because the fixed cost per unit is calculated by dividing the total fixed cost by the number of valves produced. The total fixed cost remains the same. When the number of units produced increases, the cost per unit decreases. For example, at the 10,000-unit production level, the insurance fixed cost per valve is $5.00 = $50,000 ÷ 10,000 units. At the 50,000-unit production level the insurance cost per valve is $1.00 = $50,000 ÷ 50,000 units. This is shown on the graph by the downward-sloping curve, which indicates decreases in the insurance cost per unit as production increases.

More examples of fixed costs and their cost drivers for different businesses are presented in Illustration 8:

Illustration 8: Examples of fixed costs

Fixed costs can be classified as avoidable fixed costs and unavoidable fixed costs:

Avoidable fixed costs are costs that can be avoided by choosing one alternative over another. For example, if an entity decides to discontinue a product line, all costs related to the product line will not be incurred (i.e., avoided).

For example, Friends Company may decide to outsource production of a certain part that was produced internally to a third part. This decision will result in eliminating the cost of salaries paid to employees working on the production of that part. In this case the salary cost is an avoidable cost.

Unavoidable fixed costs are costs an entity has to incur if the entity wants to stay in business. Unavoidable costs cannot be eliminated event if a product line is discontinued or a decision is made to buy products instead of producing them internally.

For example, if Friends Company stops paying taxes or renting office space, the company will not be able to continue its operations. In this case taxes and office rent are unavoidable costs.

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