Definition of 'Fixed Cost'
Fixed costs can be contrasted with variable costs, which are costs that vary in total with the level of output produced. Variable costs include the costs of raw materials, labor, and energy.
The distinction between fixed and variable costs is important for understanding the profitability of a business. Fixed costs are a sunk cost, which means that they cannot be recovered once they have been incurred. Variable costs, on the other hand, can be recovered if the business is able to produce output.
The relationship between fixed and variable costs can be illustrated with the following graph:
[Image of a graph showing fixed costs and variable costs]
The graph shows that fixed costs are constant at all levels of output, while variable costs increase as output increases. The break-even point is the point at which total revenue equals total cost. At this point, the business is making no profit or loss.
The break-even point can be calculated using the following formula:
Break-even point = Fixed costs / (Unit price - Variable cost per unit)
The unit price is the price per unit of output sold. The variable cost per unit is the variable cost per unit of output produced.
The break-even point is an important concept for understanding the profitability of a business. It can be used to determine the minimum level of output that the business must produce in order to cover its costs.
Fixed costs can also be used to calculate the degree of operating leverage. Operating leverage is a measure of how sensitive a company's profits are to changes in sales. The higher the operating leverage, the more sensitive a company's profits are to changes in sales.
Operating leverage can be calculated using the following formula:
Operating leverage = (Sales - Variable costs) / Fixed costs
The higher the operating leverage, the more a company's profits will increase as sales increase. However, the higher the operating leverage, the more a company's profits will decrease as sales decrease.
Fixed costs are an important part of understanding the financial performance of a business. By understanding the difference between fixed and variable costs, the break-even point, and operating leverage, managers can make better decisions about how to run their businesses.
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