Fixed Expenses

A fixed expense, also called a fixed cost, is a cost whose total does not change when the level of activity changes, so the same amount is incurred in a slow period as in a busy one. Because the total holds while the units divide it, the amount of fixed cost carried by each unit falls as volume rises. The steadiness holds only inside a band of activity called the relevant range, and past the top of that band the total can step up to a new level.

The Test Is Activity, Not the Calendar

A fixed cost is an unavoidable operating expense that does not change in total over the short term, even if a business experiences variation in its level of activity (OpenStax, Principles of Accounting, Volume 2, Basic Cost Behavior Patterns). Activity is whatever drives the work, whether that is units produced, hours worked or returns filed, and the test asks what the total does when that activity moves.

That is a different test from the calendar one, and the two get swapped constantly. A cost is not fixed because the bill is identical every month, and it does not stop being fixed because the landlord raises the rent at renewal. Rent that goes up at renewal is still a fixed cost, because the increase did not come from volume. A utility bill that happens to be flat for a few months is not fixed if it tracks usage, because the flatness was a coincidence of activity rather than a property of the cost.

The per-unit behavior falls out of the same definition rather than being a second rule. Despite the unchanging fixed cost of rent, as the level of activity increases, the per-unit fixed cost falls, so fixed costs remain fixed in total but can increase or decrease on a per-unit basis (OpenStax, Basic Cost Behavior Patterns).

Fixed, Variable, and Mixed Costs

Cost behavior is a three-way split, and the fixed label only means something against the other two. A variable cost is one that varies in direct proportion to the level of activity within the business, and mixed costs are those that have both a fixed component and a variable component (OpenStax, Basic Cost Behavior Patterns). Mixed is also called semi-variable, the shape of a bill that carries a standing charge plus metered usage.

The mixed category is the one that has to be taken apart before anything else works. A costing system built on behavior classifies all elements of cost into fixed and variable components, and semi-variable costs are also analyzed into fixed and variable elements (ICAI, Cost and Management Accounting, Marginal Costing). What that same three-way split does inside the indirect pool is set out in overhead.

The Relevant Range, and the Step That Breaks It

A fixed total is only true inside a band. Step costs remain constant at a fixed amount over a range of activity, and the range over which these costs remain unchanged is the relevant range, a specific activity level bounded by a minimum and a maximum amount. Within that range managers can predict cost levels, and at certain points the step costs increase to a higher amount (OpenStax, Basic Cost Behavior Patterns).

The trigger for a cost to step up is the relevant range itself, and both fixed and variable costs can take on that stair-step behavior. When additional machinery or equipment is placed into service, businesses see their fixed costs stepped up (OpenStax, Basic Cost Behavior Patterns). The practical consequence is that a fixed figure quoted on its own is incomplete. It is true at an activity level, and anyone reading it needs to know which one. What a step does to a break-even or target-profit answer belongs to cost-volume-profit analysis.

Where the Split Reaches the Books

For most businesses the fixed and variable labels are a management convention rather than a reporting requirement. A business that manufactures its own inventory meets an exception, because the inventory standard gives the two categories different allocation rules: the allocation of fixed production overheads is based on the normal capacity of the production facilities, while variable production overheads are allocated on the basis of the actual use of those facilities (Accounting Research Bulletin No. 43, Chapter 4, paragraph 5, as amended by FASB Statement No. 151, Inventory Costs). The fixed overhead absorbed into the goods waits in inventory as a cost before any period reports it as an expense. What that difference does to an allocation rate is worked through in costing overheads.

Fixed Expenses Inside a CPA Firm

For a service organization, the standard examples of fixed costs are rent, straight-line depreciation, administrative salaries and insurance (OpenStax, Basic Cost Behavior Patterns). A practice will recognize most of its own base in that list: the office, the salaried administrator, professional liability insurance, and the annual seat licenses for the tax and practice-management software.

Software is an easy line to mislabel. A charge levied per return or per filing moves with volume and is variable. The seat license does not move at all, until the firm adds a seat, and that addition is a step rather than a smooth rise. The same is true of people: a salaried preparer costs the same in a quiet week and a heavy one, and the next hire arrives as a whole new fixed block.

Fixed does not mean unchangeable, either. Committed fixed costs are the ones that typically cannot be eliminated if the company is going to continue to function, while discretionary fixed costs can be incurred in some periods and postponed in others without being eliminated permanently, with advertising campaigns and employee training given as examples (OpenStax, Basic Cost Behavior Patterns). A firm can defer training in a thin quarter. What it cannot do is make either kind of cost move with this quarter’s return count. That is why a season’s fees landing on an even fixed base swing operating income, an effect measured as the degree of operating leverage in operating leverage, and what each fee leaves behind to carry the base is contribution margin.

A Worked Example

Say a firm’s monthly fixed base holds steady while its return volume doubles between a slow month and a busy one.

Fixed base for the month                              $18,000

Slow month, 120 returns      18,000 / 120     =   $150 per return
Busy month, 240 returns      18,000 / 240     =    $75 per return

The base never moved. Doubling the returns halved the fixed cost each return carries, which is the per-unit fall in the definition made concrete. The per-return figure is still not the cost of one more return, because the next return adds nothing to the base until a step arrives, which is the distinction drawn in marginal cost.

What a Fixed Expense Is Not

Behavior is one axis, and it gets collapsed into two others that answer different questions. Whether a cost is fixed says nothing about which engagement or job it belongs to, which is the traceability question set out in direct cost; a salaried supervisor assigned to one job is both fixed and direct. It also says nothing about when the cost reaches the income statement, which is the attachment and timing question in period cost.

Common Questions

Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a trial task lets a firm’s own reviewer grade real work before the firm commits a single client file.