Business managers use several financial metrics to gauge the performance of their company. One important metric is the calculation for the fixed cost per unit of production. While this measure is simple to figure, it has several important applications for effective business management.
Calculate the fixed cost per unit by dividing the total fixed costs of the business by the number of units produced.
What Are Fixed Costs?
To start, fixed costs are usually those expenses related to general and administrative expenses:
- Office rent
- Office salaries
- Supplies, stationery and postage
- Legal and Accounting
- Travel and Entertainment
- Company car expense
- Employee benefits
- Payroll taxes
However, businesses have other fixed costs that are not so obvious. Take a salesperson, for example, who may be paid a fixed salary plus a commission. The fixed salary portion must be included in fixed overhead expenses while the commissions are a variable expense – they go up or down according to the number of sales made. Salaries of manufacturing supervisors are part of fixed overhead if their time worked does not vary with production volume. Leases on fork lifts used in the warehouse have to be paid, even if they are sitting idle in the warehouse. Electric utilities could be relatively fixed unless electricity is used in the manufacture of the product; in that case, a portion of the electric bill is variable.
What is the Formula for Fixed Cost Per Unit?
The formula to find the fixed cost per unit is simply the total fixed costs divided by the total number of units produced. As an example, suppose that a company had fixed expenses of $120,000 per year and produced 10,000 widgets. The fixed cost per unit would be $120,000/10,000 or $12/unit.
If you wished to calculate the total cost per unit, you would add the variable costs to the fixed costs before running the calculation.
What is the Breakeven Point?
Managers use the fixed cost per unit to determine the breakeven sales volume for their business. This is the production volume needed to generate enough contribution margin to pay all of the company's fixed expenses. At breakeven, the profit of the business would be $0.
However, the goal of being in business is not just to reach the breakeven point each year but to make a profit. Making a profit requires planning on how to accomplish that goal, so including the profit objective into the company's fixed costs is a good management strategy. Then, a new fixed cost per unit and revised breakeven point can be established and communicated to the sales staff. This revised production volume becomes the goal for the sales force.
How Does the Fixed Cost Per Unit Influence Pricing Strategies?
Since the fixed cost per unit will decline as the production increases, firms can incorporate this principle into their pricing strategy. Suppose a firm has a fixed cost of $120,000/year and produces 10,000 units. The fixed unit cost will be $12/unit. Now assume the production volume goes up to 12,000 units; the fixed unit cost becomes $10/unit. If the profit percentage remains the same, the firm could reduce their selling price by $2/unit, become more competitive in the marketplace and sell more of their products.
When business managers calculate their fixed costs per unit, it is important to look at all of the company's expenses, not just general overhead costs. More than likely, the firm will have production-related costs that are fixed and should be included in the calculation. With a thorough knowledge of the fixed cost per unit, management will be able to develop various pricing strategies, set production standards and establish goals for the sales department.