Every business has operating expenses — that is, 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 company. Below, get examples of each type and find out how your business can save on both.
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Fixed and variable expenses are part of your general ledger, which is how businesses keep track of their finances. A fixed expense means one that doesn’t change — it’s a set amount you pay on a recurring basis. A variable expense, on the other hand, may change due to a variety of 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 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. [Looking for help with expense tracking? Check out our recommendations for the best small business accounting software.]
Here are some key differences between fixed costs and variable costs.
Variable costs are typically part of the cost of goods sold (COGS), although fixed costs can be included in COGS as well. As prices for equipment and supplies rise, you’ll want to protect your business against inflation.
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. Below is a chart explaining how those variable expenses would work. While the packaging cost per case remains the same, the total cost of packaging rises when production is higher.
It’s critical to understand your total variable expenses from the start to see where you can potentially save money. Shaving the costs that go into selling each product makes a huge difference in your bottom line.
Here are some more examples of variable expenses:
Fixed costs are what most people refer to as overhead costs. These are the expenses you can’t reduce regardless of how much business you’re doing.
Indeed, your fixed costs may even 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 sell one phone case or a million, these costs remain the same.
Here are some common examples of fixed 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 exceed your bandwidth limit and are hit with an extra $20 fee. You’ll pay the fixed $100 no matter what, but the extra $20 is variable. Together, they make a mixed expense.
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 commission amount depends on the number of sales made. Thus, the employee’s total pay is a mixed expense.
One way to increase your business’s profitability is to find ways to reduce operational costs. This often includes cutting back on large fixed costs, but it can also entail streamlining variable costs.
Don’t leave the understanding of fixed and variable expenses to your accountants. Getting a handle on business expenses is vital for any company that is serious about its future. It allows you to develop long-term financial plans that account for variables and hypothetical situations.
Sometimes you may have to decide between paying fixed or variable costs. 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’ll get a cut of each sale — so you don’t need to pay them 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 shipping in-house.
The need to make decisions like these is why it pays to keep an eye on your fixed and variable expenses, because it might lead to fruitful negotiations and better profit margins. You should continuously review your balance sheets, income statements and other business 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.
Mike Berner and Sarah Landrum contributed to this article.