What are fixed costs?

Fixed costs are business expenses that remain relatively constant regardless of revenue or activity level. For professional service firms, fixed costs include rent, insurance, software subscriptions, administrative salaries, and loan payments. A consulting firm with $40,000 monthly fixed costs incurs these expenses whether revenue is $200,000 or $500,000. Fixed costs create leverage: once covered, additional revenue flows to profit at higher margins. Understanding fixed cost structure is critical for break-even analysis, pricing decisions, and profitability projections.

Key characteristics of fixed costs

• Constant within relevant range: Don't change based on revenue or utilization

• Time-based: Typically, monthly or annual commitments

• Examples: Rent, insurance, software, administrative staff, loan payments

• Differ from variable: Variable costs increase with activity (contractors, project materials)

• Create operating leverage: Higher fixed costs mean more profit leverage when revenue exceeds break-even

Why fixed costs matter for service firms

Fixed costs determine the break-even point and profit leverage. A firm with $100,000 monthly fixed costs and 40% contribution margin (revenue minus variable costs) needs $250,000 monthly revenue to break even. Revenue above break-even produces a profit at a 40% margin: $50,000 additional revenue generates $20,000 extra profit. High fixed cost structures create risk and reward: missing revenue targets is painful (still owes fixed costs), but exceeding targets is profitable (additional revenue less burdened by costs). Service firms shifting from the employee model (higher fixed costs) to the contractor model (lower fixed costs) sacrifice profit leverage for risk reduction.

Example: Fixed vs variable cost structure comparison

• Current structure (employee-heavy, high fixed costs):

Fixed costs:

• Employee salaries (15 FTEs): $210,000

• Benefits & payroll taxes: $52,500

• Rent: $12,000

• Software & technology: $8,200

• Insurance: $4,800

• Administrative: $18,000

• Total fixed costs: $305,500

Variable costs:

• Contractors (occasional): $15,000

• Project expenses: $8,000

• Total variable costs: $23,000 (5% of $460,000 revenue)

• Monthly revenue: $460,000

• Total costs: $328,500

• Net income: $131,500 (28.6% margin)

• Break-even: $321,600 revenue (fixed costs/contribution margin)

Alternative structure (contractor-heavy, low fixed costs):

Fixed costs:

• Core employee salaries (8 FTEs): $105,000

• Benefits & payroll taxes: $26,250

• Rent: $8,000 (smaller office)

• Software & technology: $6,500

• Insurance: $3,200

• Administrative: $12,000

• Total fixed costs: $160,950

Variable costs:

• Contractors (primary delivery): $165,000 (36% of revenue)

• Project expenses: $8,000

• Total variable costs: $173,000

• Monthly revenue: $460,000 (same)

• Total costs: $333,950

• Net income: $126,050 (27.4% margin)

• Break-even: $251,500 revenue (much lower)

Comparison:

• Employee model: Higher profit at $460K revenue ($131,500)

• Contractor model: Lower profit at $460K revenue ($126,050)

• BUT contractor model breaks even at $251K vs $322K

• The employee model has more profit leverage above the break-even point

• Contractor model has less downside risk below break-even