Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ======Fixed Costs====== Fixed Costs (also known as 'Overhead' or 'Indirect Costs') are the expenses a business must pay regardless of its level of production or sales volume. Think of it as the base cost of opening the doors each day. A baker still has to pay rent on their shop, insure their ovens, and pay the salary of their accountant, whether they sell one loaf of bread or a thousand. These costs are 'fixed' because they don't fluctuate with each additional product sold. This is the polar opposite of [[Variable Costs]], which rise and fall directly with production, like the flour and sugar used for each cake. However, it's crucial to remember that no cost is truly fixed forever. They are only fixed over a certain period and within a specific production range. If our baker's business booms and they need to open a second location, their 'fixed' rent cost will suddenly double. Therefore, investors should think of fixed costs as //step-costs//—they are flat for a while, but can jump up to a new level once the business expands beyond its current capacity. Understanding a company's fixed cost structure is essential for gauging its profitability and risk profile. ===== Why Fixed Costs Matter to Investors ===== The proportion of fixed costs in a company's total cost structure creates a powerful financial effect called [[Operating Leverage]]. This concept is a double-edged sword that can make or break an investment, and it's a critical tool for any value investor's toolkit. Here's the magic: once a company's sales have covered all its fixed costs—a point known as the [[Break-even Point]]—each additional dollar of revenue has a much larger impact on profit. Why? Because the hefty fixed costs are already paid for. For every extra unit sold, only the small variable cost is subtracted, and the rest flows almost directly to the bottom line. This is why a software company, after spending millions on development (a huge fixed cost), can earn massive profits, as the cost to sell one more software license (the variable cost) is virtually zero. The danger, however, is the flip side. In a downturn, when sales decline, the company is still saddled with those relentless fixed costs. Profits can evaporate with alarming speed, and losses can mount quickly, pushing a seemingly healthy company towards distress. A business with high fixed costs is like a sports car: it can accelerate incredibly fast in good times but can also spin out of control if conditions suddenly worsen. ===== Finding Fixed Costs on the Financial Statements ===== You won't find a neat little line item called "Fixed Costs" on a company's [[Income Statement]]. Instead, these expenses are woven into two main categories: [[Cost of Goods Sold (COGS)]] and [[Selling, General & Administrative (SG&A)]] expenses. Disentangling them requires a bit of detective work and an understanding of the business itself. ==== Examples of Fixed Costs ==== Common fixed costs that investors should be aware of include: * Rent on office space or factory facilities * Salaries of administrative, executive, and non-production staff * Insurance premiums * Property taxes * [[Depreciation]] expenses, especially when calculated using the [[Straight-line Depreciation]] method * Interest payments on corporate [[Debt]] * Basic utility bills (e.g., heating, internet access) * Annual software subscriptions ==== A Practical Estimation Method ==== Instead of trying to perform complex calculations, a value investor can gain tremendous insight by simply analyzing the nature of the business. The key is not to find an exact number but to understand the //character// of the company's cost structure. - **Software & Tech:** Think high fixed costs. Massive upfront investment in Research & Development (R&D) and marketing, but very low costs to replicate and sell the final product. - **Manufacturing:** A mix of costs. High fixed costs related to the factory, machinery (depreciation), and salaried supervisors. But also high variable costs for raw materials and assembly line labor. - **Airlines & Hotels:** Extremely high fixed costs. Airplanes, airport gate leases, and hotel properties represent enormous fixed expenses that must be paid whether they are full or empty. - **Consulting & Services:** Typically low fixed costs. The main cost is employee salaries, which can be adjusted (a variable cost) based on the number of client projects. By identifying the business model, you can immediately get a feel for whether its profits will be stable and steady or volatile and highly sensitive to changes in sales. ===== The Investor's Takeaway ===== Understanding a company's fixed costs is fundamental to the value investing philosophy of buying good businesses at a fair price. It directly impacts your assessment of risk and your calculation of a [[Margin of Safety]]. ==== The Double-Edged Sword of Leverage ==== The high operating leverage created by fixed costs means you must be extra cautious. * **High Potential:** A business with high fixed costs that is poised for growth can be a goldmine. As it grows, its [[Profit Margin]] can expand dramatically, leading to explosive earnings growth and a soaring stock price. This is the principle of //scalability//. - **High Risk:** These same businesses are particularly vulnerable to economic downturns or competitive pressure. Investors in high-fixed-cost companies in [[Cyclical Industries]] (like automotive or airlines) must be prepared for volatility. When sales dip, these companies can burn through cash very quickly. ==== What to Look For ==== * **Predictable Revenue:** A company with high fixed costs is far more attractive if it has a stable, recurring, or predictable revenue stream. This makes it much easier to cover the overhead in good times and bad. A company like [[Microsoft]], with its long-term enterprise contracts, is a great example. * **Dominant Market Position:** A strong competitive advantage, or [[Moat]], allows a company to protect its pricing and sales volume, providing a buffer to cover its fixed costs. * **Low Debt:** A company with high operating leverage (high fixed costs) should ideally have low financial leverage (low debt). A combination of the two can be a lethal cocktail in a recession, as the company must service both its operational overhead and its interest payments.