Fixed Overheads: Meaning, Calculation, Examples, and Business Importance

 

Definition of Fixed Overheads

Fixed Overheads are the indirect costs of production or business operations that remain constant regardless of the level of output or sales activity within a given range. These costs do not fluctuate in the short term and must be paid whether the company produces 100 units or 10,000 units.

Meaning of Fixed Overheads in Detail

Fixed overheads are expenses that businesses must bear regularly, even if there is no production activity. Unlike variable costs, which change with the volume of production, fixed overheads remain stable. These are essential for keeping the business functional.

For example, a manufacturing company must pay factory rent, permanent staff salaries, and insurance costs regardless of how many products it produces in a month. These expenses are crucial for maintaining production capacity but do not directly vary with output levels.

Components of Fixed Overheads

To understand the concept better, fixed overheads can be broken down into:

• Rent and Lease Expenses – Payments for factory buildings, offices, or warehouses.

• Salaries of Permanent Staff – Fixed monthly pay to employees not linked with production volume.

• Insurance Premiums – Regular payments for factory insurance, machinery, or business assets.

• Depreciation – Reduction in value of long-term assets over time.

• Utilities with Fixed Minimums – For example, a minimum electricity or internet charge even if usage is low.

• Property Taxes – Government-imposed levies on business properties.

Formula / Calculation of Fixed Overheads

Fixed overheads are not calculated directly like variable costs, but in cost accounting, they are usually absorbed into product cost using an absorption rate.

Formula:

$$\text{Fixed Overhead Absorption Rate (FOAR)} = \frac{\text{Budgeted Fixed Overheads}}{\text{Budgeted Activity Level}}$$

Where activity level could be labor hours, machine hours, or production units.

Example Calculation

Suppose a factory has ₹500,000 as budgeted fixed overheads for the year and expects to produce 50,000 units.

$$\text{FOAR} = \frac{₹500,000}{50,000} = ₹10 \, \text{per unit}$$

This means each unit will carry an overhead absorption of ₹10.

Journal Entry for Fixed Overheads (Accounting Treatment)

In cost accounting, fixed overheads are allocated to production.

Example:
Company pays factory rent of ₹100,000.

Journal Entry:

Factory Overhead A/c      Dr. ₹100,000  
       To Bank A/c                        ₹100,000  

When overhead is absorbed:

Work-in-Progress A/c      Dr. ₹100,000  
       To Factory Overhead A/c             ₹100,000  

If there is under- or over-absorption, adjustment is made in the costing Profit & Loss Account.

Detailed Illustration of Fixed Overheads

Let’s assume a company has the following annual fixed overhead costs:

Particulars	Amount (₹)
Factory Rent	200,000
Salaries (Permanent Staff)	150,000
Insurance	50,000
Depreciation	100,000
Property Taxes	25,000
Total Fixed Overheads	525,000

Expected Production: 105,000 units

$$FOAR = \frac{525,000}{105,000} = ₹5 \, \text{per unit}$$

So, each unit produced will include ₹5 fixed overheads in its cost.

Key Features of Fixed Overheads

• Remain constant in the short term

• Not directly linked with output level

• Represent capacity costs

• Allocated using absorption rate methods

• Essential for cost control and pricing decisions

Importance of Fixed Overheads in Business

• Pricing Decisions – Helps in determining cost per unit.

• Break-Even Analysis – Fixed overheads are crucial in calculating contribution margin.

• Profit Planning – Businesses must cover fixed costs before making profits.

• Cost Control – Identifies unavoidable costs and ensures efficiency.

Advantages and Disadvantages

Advantages:

• Provides stability in cost planning.

• Encourages efficient use of resources.

• Helps in long-term investment planning.

Disadvantages:

• Creates financial burden during low production periods.

• Not easily adjustable in the short term.

• Inaccurate allocation may distort product cost.

Usage of Fixed Overheads

• Used in cost accounting for absorption costing.

• Applied in budgeting and forecasting.

• Essential in break-even and marginal costing.

• Basis for pricing decisions in manufacturing.

Case Studies

Case Study 1: Automobile Industry (Tata Motors)
Tata Motors incurs heavy fixed overheads like factory rent, engineering salaries, and depreciation of plants. Even during low sales periods, these costs continue, forcing the company to maintain minimum production.

Case Study 2: Hospitality Industry (Hotels)
Hotels must bear property rent, staff salaries, and maintenance expenses regardless of room occupancy. During off-seasons, these fixed overheads affect profitability.

Practical Example

A bakery has monthly fixed overheads of ₹200,000 (rent, salaries, utilities). If it produces 20,000 loaves in a month, each loaf must absorb:

$$\frac{200,000}{20,000} = ₹10$$

Thus, even before considering raw material and variable costs, each loaf carries ₹10 in fixed overheads.

Common Mistakes or Misunderstandings

• Believing fixed overheads never change (they can change in the long run).

• Treating fixed costs as avoidable – most are unavoidable.

• Misallocation leading to incorrect product pricing.

Real-Life Applications and Legal Implications

• Taxation: Some fixed overheads like depreciation and insurance are deductible expenses.

• Contracts: Companies must factor in fixed overheads when bidding for government tenders.

• Financial Analysis: Banks and investors assess fixed overheads to judge sustainability.

FAQs

Q1. Are fixed overheads the same as fixed costs?
Not exactly. Fixed costs may include direct expenses, while fixed overheads are specifically indirect fixed costs.

Q2. Do fixed overheads affect profit margins?
Yes, higher fixed overheads increase break-even point, reducing profit margins at lower sales volumes.

Q3. Can fixed overheads ever become variable?
In the long run, businesses can renegotiate leases or restructure staff, making them flexible.

Expert Tip from Learn with Manika

“Always track your fixed overheads separately from variable costs. This helps in smarter pricing, better break-even analysis, and ensures your business stays profitable even in tough times.”

Related Terms

• Variable Overheads
• Semi-Variable Costs
• Contribution Margin
• Absorption Costing
• Break-Even Analysis