Fixed cost is the expense that the company would continue to incur without any change (even if there is a change) in the number of goods produced or sold. This cost is incurred by the company regardless of any business activity and is useful in calculating break-even analysis to determine the pricing of goods, based on the level of production of a company. Some examples of fixed costs are depreciation on large infrastructure asset, insurance, salaries at head office, rent, interest on long term loans etc.
Since fixed cost is that cost to a company which is unavoidable even in case of total shutdown, it plays an important role in determining the profitability of the company. Incase of manufacturing companies, fixed cost, when calculated on per item basis, reduces for every additional item that is produced. Therefore a company is said to be working or achieving economies of scale when it is producing enough goods to distribute the fixed cost over a larger number of units produced and sold.
For example, let’s assume a company produces 1,00,000 chocolates a year for Rs. 1,00,000. The cost of Rs. 1,00,000 can be divided into Rs. 50,000 for administrative, rental, marketing purposes which are generally fixed. If the company decides to produce 2,00,000 chocolates next year, the production cost of the company will only rise to Rs. 1,50,000 (Rs. 0.75 per chocolate) because it can spread the fixed cost over more number of chocolates. In this case even though the total cost of the company increases from Rs. 1,00,000 to Rs. 1,50,000, each chocolate becomes cheaper to produce and therefore the profitability margin will increase.
Companies tend to incur huge fixed cost in order to reduce their variable costs, which in turn increases the operating leverage. This is because once the company achieves the breakeven, any further profit earned by the company will give higher profits. If the sales volume are lower in such cases the decline in profit will be greater. One of the real life examples is Reliance Jio which has invested heavily in Fixed Costs and has achieved huge sales volume in the form of large subscriber base, increasing profits of the company.