fixed costs

Examples of fixed costs in the following topics:

• Leverage Models

  • Operating leverage models include ratios, such as fixed costs to variable costs/total costs, fixed costs to income, and the DOL.
  • The total fixed costs are $1,000.
  • Just as we interpret ratios of debt to equity and debt to total assets when analyzing financial leverage, when analyzing operating leverage, we can compare fixed costs to variable costs and fixed costs to total costs.
  • Thus, for a given level of sales and profit, the DOL is higher when fixed costs are higher.
  • Operating leverage is equal to total fixed costs divided by operating income.

• Defining Operating Leverage

  • Specifically, it is the use of fixed costs over variable costs in production.
  • For example, replacing production workers (variable cost) with robots (fixed cost) .
  • As operating leverage increases, more sales are needed to cover the increased fixed costs.
  • These include the ratio of fixed costs to total costs, the ratio of fixed costs to variable costs, and the Degree of Operating Leverage (DOL).
  • The ratios of fixed cost to total costs and fixed costs to variable costs tell us that if the unit variable cost is constant, then as sales increase, operating leverage decreases.

• Break-Even Analysis

  • The variable cost per unit is $5, and the total fixed costs are $1,000. 67 units must be sold in order to break even.
  • Recall that operating leverage describes the relationship between fixed and variable costs.
  • Having high operating leverage (having a larger proportion of fixed costs compared to variable costs) can lead to much higher profits for a company.
  • To find the amount of units required to be sold in order to break even, we simply divide the total fixed costs by the unit contribution margin.
  • FC = fixed cost curve.

• Economic Order Quantity Technique

  • The required parameters to the solution are the total demand for the year, the purchase cost for each item, the fixed cost to place the order, and the storage cost for each item per year.
  • Variables for the function are: Q = order quantity, Q*= optimal order quantity, D = annual demand quantity, S = fixed cost per order (not per unit, typically cost of ordering and shipping and handling.
  • This is not the cost of goods), H = annual holding cost per unit (also known as carrying cost or storage cost) (warehouse space, refrigeration, insurance, etc., usually not related to the unit cost).
  • Total Cost = purchase cost + ordering cost + holding cost
  • Ordering cost: This is the cost of placing orders: each order has a fixed cost S, and we need to order D/Q times per year.

• Factors Controlled by the Firm

  • When a higher proportion of debt is chosen, the cost of debt must factor in credit risk.
  • Higher levels of debt can result in wider variations to earnings due to higher fixed obligations that must be paid (interest to debt holders).
  • Generally, the use of financial leverage - the financing of assets with fixed obligations, i.e., debt - will improve financial performance whenever returns are higher than the costs of obtaining funds.
  • The level of fixed costs used to operate the business needs to be considered and factored into a company's cost of capital.
  • For example, higher fixed costs can result in wider variations to operating income from numerous factors - increased competition, slower economic growth, etc.

• The Cost of Preferred Stock

  • It will pay a fixed dividend of $10 each year.
  • The cost of preferred stock is 13%.
  • With preferred shares, investors are usually guaranteed a fixed dividend forever.
  • If preferred dividend is known and fixed, we can use the following equation to calculate the cost of capital for preferred stock .
  • The dividend is usually specified as a percentage of the par value or as a fixed amount.

• Depreciation

  • Depreciation is the process by which an asset is used up, and its cost is allocated over a period of time.
  • The allocation of the cost of an asset to periods in which it is used up affects net income.
  • One such cost is the cost of assets used but not currently consumed in the activity.
  • Such costs must be allocated to the period of use.
  • The business records depreciation expense as an allocation of such costs for financial reporting.

• Fixed Assets Turnover Ratio

  • Fixed-asset turnover is the ratio of sales to value of fixed assets, indicating how well the business uses fixed assets to generate sales.
  • According to International Accounting Standard (IAS) 16, Fixed Assets are assets which have future economic benefit that is probable to flow into the entity and which have a cost that can be measured reliably.
  • Fixed-asset turnover is the ratio of sales (on the profit and loss account) to the value of fixed assets (on the balance sheet).
  • Fixed asset turnover = Net sales / Average net fixed assets
  • Fixed-asset turnover indicates how well the business is using its fixed assets to generate sales.

• Inputs to COGS

  • Cost of goods sold (COGS) refer to the inventory costs of the goods a business has sold during a particular period.
  • Costs include all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.
  • Costs of payroll taxes and employee benefits are generally included in labor costs, but may be treated as overhead costs.
  • Activity based costing attempts to allocate costs based on those factors that drive the business to incur the costs.
  • Fixed production overheads are often allocated based on normal capacities or expected production.

• Defining Financial Leverage

  • Financial leverage, in a corporate finance sense, exists when a company finances assets and internal operations through fixed obligations.
  • Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives.
  • Financial leverage is the financing of assets and internal operations with fixed obligations.
  • Generally, the use of financial leverage will improve financial performance, as long as returns are higher than the costs of obtaining funds, or the cost of capital.
  • As a company uses more financial leverage, higher levels of operating income are needed to cover the additional fixed obligations (interest on debt and fixed dividends on preferred stock).