There’s a cost to doing business and it usually comes in two forms: fixed expenses and variable expenses.
Described in their most basic forms, fixed expenses don’t change regardless of how your business is doing.
Variable expenses are constantly shifting and can’t always be predicted with total certainty.
Knowing fixed and variable expenses are crucial to understanding a business’s sustainability and determining where the money is going.
We’ll explain exactly what each one means and how these differing expenses can impact your business.
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By definition, variable expenses are a cost that changes depending on your production. Let’s say you’re selling a widget of some sort. How about phone cases? Here’s a chart explaining how variable expenses work.
|Cases Produced||Packaging Costs||Total Cost|
The packaging costs per case remains the same, but the total cost spent on packaging rises when production is higher. This is a textbook variable expense. A detailed look at variable costs can be seen in this part-by-part breakdown of an iPhone.
Another example would be electricity used in fulfilling a task. Let’s say that the longer you’re in the office to finish each assignment, the higher your electricity bill. Even if you’re being frugal with your utilities and being energy efficient, these expenses continue to rise the longer you’re in the office. Other examples of variable expenses that you might encounter include credit card fees, hourly wages and shipping costs.
Obviously, it’s a good thing when business is booming, as more products or services sold means more revenue. From the start, it’s critical to get a deep understanding of all the variable expenses in order to see where some savings can be made. Shaving the costs that go into each product makes a huge difference on your bottom line.
With variable expenses settled, let’s take a look at fixed costs.
At its core, fixed costs are what most people refer to as overhead. They’re the types of expenses that don’t really change regardless of how much business you’re doing.
The easiest example of this is rent. Whether you’re renting out an office or a retail spot, the rent stays the same for the foreseeable future. If you’re online, a similar expense would be the cost of renewing domains or licensing software. Whether you’re ramping up sales or just getting started and not yet hitting the market, these fixed costs remain flat.
Other examples of fixed costs would be insurance and salaries. Depending on the type, taxes can be either fixed or variable. A property tax is fixed while a value-added tax would be variable since it changes based on how many products or services you provide.
Of course, fixed costs can change 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 production. Whether you sold one or one million widgets, a fixed cost remains the same.
Mixed (Semi-Variable) Expenses
A third category of expenses is a mixture of both fixed and variable. Let’s say you’re paying $100 for hosting each month, but go over your bandwidth limit and are hit with an extra $20. The $100 is fixed 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 he or she earns on each sale is variable, as the total cost changes depending on the number of sales made.
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Weighing Your Options
Don’t leave the understanding of fixed and variable expenses only to the accountants. Getting a handle on the expenses are critical for any company serious about its future. Figuring it out means there can be long-term modeling based on any variables and hypothetical situations.
There also comes times when you’ll have to decide between paying fixed or variable costs, as there are benefits and risks associated with each. If you’re an online retailer, you might choose to outsource each sale to a third party so you won’t need to worry about shipping, for example. If you pay the third party with variable expenses, meaning they get a cut of each sale, that could work in your favor. If you don’t sell anything, you don’t need to worry about making a payment.
However, there could be a time when sales are so high that these variable costs total a significant amount of money. At that point, you need to consider whether to make a fixed expense of hiring the staff to handle this in-house.
Making decisions like these is why it pays to keep an eye on fixed and variable expenses, as it might lead to fruitful negotiations. An understanding could be the most effective way of figuring out what’s best for you and your company.