Every business has operating expenses – the costs of running the business – and they usually take two forms: fixed expenses and variable expenses. Understanding the difference between the two gives you a clearer picture of not just where your money is going, but also how each expense impacts your business.
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Fixed vs. variable expenses
A fixed expense basically just means one that doesn't change – it is a set amount that you pay on a recurring basis. A variable expense, on the other hand, may change due to various factors – which means you can't always predict exactly what it will cost. Both types of expenses can be direct or indirect costs.
These terms exist to differentiate between the different types of costs businesses are expected to pay. As a business owner, you will have both types of expenses, so it's important to distinguish between the two and create a budget accordingly. [Want more information? Check out our recommendations for the best small business accounting software.]
Here are some key differences between fixed costs and variable costs:
- Fixed expenses remain static over a set period of time; variable expenses fluctuate depending on external factors.
- Fixed expenses are not impacted by production output. For example, you're going to make the same office lease payment every month regardless of how much work you do in that office. Variable expenses, however, may increase or decrease based on your output, because you'll need to buy more raw goods and spend more on hourly labor in order to produce more output.
- Fixed expenses are often time-related, such your monthly office lease payment. Variable expenses are more often volume-related, such as the amount of time your hourly employees work each week.
By definition, a variable expense is a cost that changes depending on your production level. In other words, your sales volume directly impacts your variable expenses.
For example, let's say you sell phone cases. Here's a chart explaining how those variable expenses would work.
|Cases produced||Packaging costs||Total cost|
The packaging cost per case remains the same, but the total cost of packaging rises when production is higher. This is a textbook variable expense. You can see a more detailed example of variable costs in this part-by-part pricing breakdown of an iPhone.
Obviously, it's a good thing when business is booming and you have decent cash flow, as more products or services sold means more revenue. You want to develop a deep understanding of your total variable expenses from the start in order to see where you could save money. Shaving the costs that go into each product makes a huge difference in your bottom line.
Examples of variable costs
Here are some common examples of variable expenses to account for in your monthly budget:
- Packaging costs
- Utilities, like electricity and water
- Credit card and bank fees
- Hourly wages and direct labor
- Shipping costs
- Raw materials
- Sales commissions
Fixed costs are what most people refer to as "overhead." These are the expenses that don't really change regardless of how much business you're doing.
Of course, your fixed costs can increase over time. Rents go up, salaries increase, and insurance premiums tend to rise. However, these costs are fixed in the sense that they don't change based on your production volume. Whether you sold one phone case or 1 million, the total fixed cost is the same.
Examples of fixed costs
Here are some common examples of fixed expenses:
- Car payments
- Interest expenses
- Property taxes
- Leased equipment
Mixed (semi-variable) expenses
A third category of expenses is a mixture of fixed and variable. Let's say you're paying $100 for web hosting each month, but one month you go over your bandwidth limit and are hit with an extra $20 fee. You'll pay the $100 no matter what, but the extra $20 is variable.
Another example would be if you have a salesperson working on commission. The base salary for this employee is fixed, but the commission they earn on each sale is variable, as the total cost changes depending on the number of sales made.
How to save on variable and fixed costs
Saving on variable costs
If you have high variable costs, here are some ways to decrease your spending:
- Search for ways to lower your utility bills. Use less electricity and water wherever possible, and opt for a cheaper internet or phone plan that still meets your business's needs as a business. Monitor how much money you spend on utilities each month, which will reveal areas of waste and motivate your company to be more energy efficient.
- Maintain the minimum balance in your bank accounts. Many banks require a minimum amount of money to be kept in specific accounts each month. If this is the case, make sure you always have this amount in your account to avoid unnecessary fees.
- Pay your credit card bills on time and in full. Late fees and interest charges can quickly become expensive – and they're avoidable if you keep an organized payment schedule and budget for them.
- Streamline packaging and shipping. By optimizing your packaging and shipping processes, you can reduce the costs of each. Find ways to use less equipment, tailor the sizes of packages to the product, and consolidate shipments as much as possible.
Saving on fixed costs
If you have high fixed costs, here are some ways to better distribute your budget:
- Renegotiate your rent or find a more affordable place. If you want to lower your monthly cost for rent, reach out to your landlord to negotiate a lower cost in exchange for a longer lease or a lease extension. If you find your current location is larger than you need or is breaking the bank, look to downsize or move to a more affordable location.
- Reduce insurance premiums. You may be able to do this by installing features that eliminate or lower certain risks. For instance, if you pay for theft protection, you could install a security system rather than paying that ongoing cost. You could also negotiate lower premiums if you have a good customer history with the insurance company.
- Lower your monthly lease or loan payments. It doesn't hurt to ask for lower monthly payments on your leases or loans. Leasing companies and banks are often willing to extend your payments over a longer period of time to decrease the amount you must pay each month. While this might increase the interest rate, it can lower your costs until you are in a more financially comfortable place.
- Only have a few managerial positions. Rather than hiring several managers and paying all of them a high salary, have a few quality ones you can appropriately compensate. You may be able to do this by merging similar departments under one manager. [Read related article: 10 Ways to Drastically Cut Business Costs]
Weighing your options
Don't leave the understanding of fixed and variable expenses to the accountants. Getting a handle on business expenses is critical for any company serious about its future, as it allows you to develop long-term financial plans that account for variables and hypothetical situations.
There may also be times when you have to decide between paying fixed or variable costs, and there are benefits and risks associated with each. For example, if you're an online retailer, you might choose to outsource each sale to a third party so you don't need to handle shipping. It could work in your favor to pay the third party with variable expenses – meaning they get a cut of each sale – as you won't need to pay anyone if you don't sell anything.
However, there could come a time when your sales are so high that these variable costs total a significant amount of money. At that point, you'll need to consider whether it would save you money to invest in the fixed expense of hiring staff to handle the shipping in-house.
The need for decisions like these is why it pays to keep an eye on your fixed and variable expenses, as it might lead to fruitful negotiations. You should continuously review your balance sheets, income statements and other financial statements to make any necessary adjustments. Understanding how these costs work will help you figure out what's best for your company at all times.
Sarah Landrum contributed to the writing in this article.