Fixed charges are overhead costs that are not closely associated with activity levels. That is, these costs will likely be incurred by a business even if there are greatly reduced sales.
Fixed Charges are any type of fixed expense that recurs on a regular basis. Fixed charges can include insurance, salaries, utilities, vehicle payments, loan payments and mortgage payments. These charges allow both individuals and businesses to create more predictable budgets and estimate their cash flows more accurately.
Both businesses and individuals can have fixed charges. Businesses may have liability or malpractice insurance, while individuals pay car and home insurance. Businesses can often deduct many or all of their fixed charges as business expenses.
Examples of fixed charges are:
- Interest expense
- Lease payments
- Mortgage payments
- Pension payments
If fixed charges are associated with production activities, they are rolled into an overhead cost pool and then allocated to the production units manufactured during the period to which the charges apply. If the fixed charges are instead associated with administrative activities, they are charged to expense as incurred.
Fixed charges can represent the majority of all expenditures incurred by a business, especially if the organization has a large fixed asset base that it must maintain, irrespective of the actual level of sales. Thus, an oil refinery can be expected to have a much higher proportion of fixed charges than a consulting practice.
When expenses are largely comprised of fixed charges, it is much easier for a business to predict its future expenses via a budget, since these costs rarely change.
If a business is subject to a large proportion of fixed charges, it can make sense to routinely compare these charges to an adjusted earnings figure, to see if the business has sufficient earnings to pay for the charges. Use the fixed charge coverage ratio to conduct this analysis.