A Fixed cost is an expense that stays the same whether business is booming or flagging. Monthly rent is a good example of a cost that doesn't vary with a company's volume of business.
Fixed cost is an accounting category that can give clues about a business's ability to profit when conditions change, and about how dramatic the change in profit might be. A company with a large percentage of fixed costs (as compared to variable costs) that it is paying regardless of how business is doing, can realize higher margins on increased production. If the lights are already on, the taxes are already being paid, and the machines are already being leased, then production can be increased with this large base of expenses already in place. So a larger portion of additional sales can be retained as profit.
Of course, if things turn sour, the company is stuck with its fixed costs. Although they can be reduced over time if, for instance, offices are closed and the rent is no longer paid.
It's comparable to how one more fifth-grader can be added to a class with only an incremental increase in expenses. Additional textbooks and perhaps a desk would have to be purchased, but big-ticket items including the teacher's salary and the heating bill are on the books with or without that student.
Companies with a lower percentage of fixed costs (and higher percentage of variable costs), on the other hand, might see margins increase less, since they have to ramp up spending to a greater degree to increase production to bring in more money. Expenses for items such as salaries and raw materials, which need to rise for sales to rise, are a larger portion of expenses.
On the upside, if demand for the company's product drops dramatically, it can respond quickly by cutting the variable costs.
Operating leverage looks at the relation between a company's fixed and variable costs.
Related Fool Articles
Recent Mentions on Fool.com
- The Long-Term Risk in McDonald's Turnaround Plan
- 3 Reasons Dividend Investors Should Love Calumet Specialty Products Partners' Latest Earnings Result
- Volkswagen Reveals (Some) Plans to Fix Its Cheating Diesels
- Costco Wholesale Corporation at All-Time Highs: Here Is Why
- Guess? Inc. Beats the Retail Slump With Solid Results
- This Is What Is Stressing Halliburton Company