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Fixed Versus Variable Expenses

Understanding how to identify fixed versus variable expenses can help you with your budget and cash flows. There are two main kinds of expenses, fixed and variable. A mixed expense is a hybrid between the two that we'll cover in a bit.





Fixed Expenses

Fixed expenses are not dependent on your production or sales output. These are things like rent, insurance costs, advertising expense, etc. While some of these may have an effect on your sales they are not going to be determined by your sales. Your sales are going to increase with higher advertising rates (we hope), but your advertising rates are not going to automatically increase because of increased sales. Administration labor expenses, accounting/bookkeeping fees, etc also fall into this category.


Fixed expenses tend to be expense categories that you can target for a more efficient budget, especially in the beginning stages of your business. For example, advertising expense can be easier to reduce than inventory expense in many cases. You can also try to limit your rent expense by renting a less expensive office space or working from your home if feasible.


Variable Expenses

Variable expenses are directly related to the production and/or sales of your business. These are things like raw materials to produce your product, labor expenses for your employees performing the services you are selling, etc. These can be harder to limit in most cases than fixed costs. You can't provide plumbing services without a plumber, but you could reduce advertising for the month of May to save some funds.


Variable expenses are not completely immune from the potential to save some money, but it needs to be done carefully. When reducing your variable expenses ask yourself if the reduction will lower the quality of the services or products you provide? Will it cause you to not be able to keep in stock the items you need? How does it effect your customer satisfaction?


Budgeting Basics

Now that you understand the difference between fixed and variable costs let's talk about some basic budgeting tips you can use that may help you with your cash flows. Gross profit is a number calculated by taking your sales (revenue) and subtracting your cost of goods sold. Your cost of goods sold are the expenses that go directly into providing your services or producing your product. That sounds a lot like variable expenses right? Because variable expenses are cost of goods sold. When thinking about it this way your variable expenses should be used to price your products and services. Your selling price should be calculated based on the variable expenses that go into building your product. That's a very simplified explanation on pricing and there are more factors that make up a good pricing model, but the bottom line is your pricing must cover your variable expenses that go into each product and service.


Your gross profit then needs to be enough to cover your fixed expenses. You can increase your gross profit by selling more products or services and/or increasing your fees so you have a higher profit margin. Once you cover your fixed expenses any additional gross profit flows to net profit or net income. This is your take home income.


Mixed Expenses

Now let's throw a bit of a curve ball your way. There are also expenses that share characteristics of both fixed and variable expenses. For example, you may have an electricity plan for your production plant that starts with a flat rate per month and then adds a certain amount per kilowatt hours on top of that. The flat rate portion is fixed and the rate per kilowatt hours becomes variable. Your electricity consumption in your plant should vary depending on the number of products you are making. If you make 1,000 units one month your electricity should be lower than the month you make 10,000 units. Mixed expenses can be broken down for budgeting purposes into the variable and fixed components and then the same rules can be applied.


Final Tips

A few final tips when creating a budget based on fixed and variable expenses:


  • Leave some wiggle room, especially if you are in an industry that common encounters unexpected expenses

  • Think about when all of these expenses are due, some may be prepaid expenses while others are due 30 to 60 days after the services are rendered, this influences your cash flow

  • Use historical data to help you with an expense that tends to fluctuate, chances are there may be a pattern that will help you better estimate the expense

  • Quality is important, don't try to skimp on quality to save some money, you may be better off raising your prices

  • Don't expect to compete with the big players right away, you may not be able to compete with a company with large buying power, but you may be able to outperform them when it comes to things like customer service