Fixed cost

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Decomposing Total Costs as Fixed Costs plus Variable Costs.

In economics, fixed costs are business expenses that are not dependent on the activities of the business [1] They tend to be time-related, such as salaries or rents being paid per month. This is in contrast to variable costs, which are volume-related (and are paid per quantity).

In management accounting, fixed costs are defined as expenses that do not change in proportion to the activity of a business, within the relevant period. For example, a retailer must pay rent and utility bills irrespective of sales.

Along with variable costs, fixed costs make up one of the two components of total cost. In the most simple production function, total cost is equal to fixed costs plus variable costs.

[edit] Areas of confusion

Fixed costs should not be confused with sunk costs. From a pure economics perspective, fixed costs may not be fixed in the sense of invariate; they may change (and probably will over time), but are fixed in relation to the quantity of production for the relevant period. For example, a company may have unexpected and unpredictable expenses unrelated to production. On the other hand, production output may vary sharply without changing the fixed costs.

Strictly speaking, there is not absolute fixed cost in long-run if the relevant range is long enough. Investments in facilities, equipment, and the basic organization that can’t be significantly reduced even for short periods of time without making fundamental changes are referred to as committed fixed costs. Discretionary fixed costs usually arise from annual decisions by management to spend on certain fixed cost items.

In business planning and management accounting, usage of the terms fixed costs, variable costs and others will often differ from usage in economics, and may depend on the intended use. Some cost accounting practices such as activity-based costing will allocate fixed costs to business activities, in effect treating them as variable costs. This can simplify decision-making, but can be confusing and controversial.[2] [3]

In accounting terminology, fixed costs will broadly include almost all costs (expenses) which are not included in cost of goods sold, and variable costs are those captured in costs of goods sold. The implicit assumption required to make the equivalence between the accounting and economics terminology is that the accounting period is equal to the period in which fixed costs do not vary in relation to production. In practice, this equivalenceies does not always hold, and depending on the period under consideration by management, some overhead expenses (e.g. sales, general and administrative expenses) can be adjusted by management, and the specific allocation of each expense to each category will be decided under cost accounting.