What it is:
Fixed costs are costs that do not change when the quantity of output changes. Unlike variable costs, which change with the amount of output, fixed costs are not zero when production is zero.
How it works/Example:
Some examples of fixed costs include rent, insurance premiums, or loan payments. Fixed costs can create economies of scale, which are reductions in per-unit costs through an increase in production volume. This idea is also referred to as diminishing marginal cost.
For example, let's assume it costs Company XYZ $1,000,000 to produce 1,000,000 widgets per year ($1 per widget). This $1,000,000 cost includes $500,000 of administrative, insurance, and marketing expenses, which are generally fixed. If Company XYZ decides to produce 2,000,000 widgets next year, its total production costs may only rise to $1,500,000 ($0.75 per widget) because it can spread its fixed costs over more units. Although Company XYZ's total costs increase from $1,000,000 to $1,500,000, each widget becomes less expensive to produce and therefore more profitable.
Some fixed costs change in a stepwise manner as output changes and therefore may not be totally fixed. Also note that many cost items have both fixed and variable components. For example, management salaries typically do not vary with the number of units produced. However, if production falls dramatically or reaches zero, layoffs may occur. Economically, all costs are variable in the end.
