There are countless ongoing tasks involved with running a business, but one of the most critical is managing your business’s financials. Along with recording your revenue and paying off debt, you also have to track your various expenses.
Understanding your company’s fixed expenses and variable expenses can help you maintain healthy cash flow, budget more effectively, and increase your profits. Keeping reading for more information on what fixed expenses are, why they matter, and how to keep them under control.
What is a fixed expense?
Fixed expenses are business costs that remain the same from month to month, regardless of your business’s changing output or revenue. Sometimes called overhead costs, fixed costs are usually the minimum costs your business needs to pay to keep your operation running.
Examples of fixed expenses include:
Rent or mortgage payments
Some businesses have high fixed expenses because of the industry or nature of work. Manufacturing, retail, and automobile companies, for example, usually have to pay a high rent or mortgage to cover insurance policies and maintain a storefront, factory, or warehouse.
Other businesses, like online stores or social media agencies, may have lower fixed expenses if they don’t have to pay for a brick-and-mortar store or office. However, businesses with low fixed expenses may end up spending more money on their variable expenses.
Fixed expenses vs. variable expenses
True to their name, variable expenses are business costs that vary from month to month. Depending on your particular business, spending more on your variable expenses could improve the quality of your offerings and result in higher sales or revenue; however, allocating more money toward variable expenses can also limit your cash flow.
Examples of variable costs include:
Marketing and advertising
Hourly wages for employees
Businesses with high variable costs include restaurants, e-commerce sites, and niche businesses like pet sitting or consulting. In general, the higher the sales demand for these types of businesses, the greater the variable costs. A restaurant or food truck is a prime example. If you have more customers, you’ll inevitably need to spend more on food and labor to serve those people.
Why is it important to understand fixed and variable expenses?
Understanding your business expenses is the first step to running a profitable operation. Without knowing how much cash you spend each month, it can be hard to price your products or services at the correct cost structure, maintain positive cash flow, pay off your loans, or grow your revenue.
Totaling your expenses, on the other hand, gives you a clear idea of how much it costs to run your business—and where you might be able to save. Understanding your fixed and variable costs can help you:
Identify gaps in cash flow
Save up reserves to plan for a slow period
Determine where you’re overspending and figure out how to reduce expenses
Link costs to their impact on profit
Budget for upcoming quarters
Create an annual budget
How to calculate average fixed costs
Calculating your business’s average fixed costs gives you a sense of how much money your business spends per unit in fixed costs, which can help you make smarter decisions around your overhead and production costs. Keep in mind, though: this number doesn’t factor in variable expenses, so it’s not the only figure you should look at.
Here’s the formula for average fixed costs:
Average fixed cost = Total fixed costs / Number of units produced
To total your fixed expenses, review your most recent annual income statement, then add up any expenses that appeared regularly from month to month and didn’t change.
Let’s say you run an online store selling sunglasses. Your total fixed costs for the year were $60,000 and you produced 7,000 sunglasses. Using the formula, your average fixed cost per pair of sunglasses would be $8.50. However, if you can produce a greater number of products—say, 10,000 sunglasses—with the same amount of fixed expenses, you can lower your average fixed cost per item to $6.
How to calculate your business’s breakeven point
It’s also helpful to calculate your business’s breakeven point in units; this figure is the amount of units you need to produce to cover all your fixed and variable expenses. Figuring out your breakeven point can help you avoid profit losses by setting realistic sales goals for each week, month, quarter, and year.
The breakeven formula is:
Breakeven point = Fixed expenses / (Price per unit x variable cost per unit)
You can use the average variable cost formula to determine the variable cost per unit. The formula is:
Average variable cost = Variable costs / Total units produced
Let’s use the same example of running an online sunglasses store. In addition to your $60,000 of fixed expenses, let’s say your business sells each pair of sunglasses for $14 and it costs $9 in materials, labor, packaging, and shipping to make each pair (the variable cost per unit). Using the formula, your business would have to make and sell 476 pairs of sunglasses each year to break even. However, to be profitable, you’d have to make and sell significantly more than that.
How to reduce fixed expenses
Reducing your business’s fixed expenses can be tricky, but even small adjustments can go a long way toward freeing up your cash flow. If you want to lower your fixed costs, here are a few ways to do it:
Negotiate a lower rent with your landlord
Sublease part of your building to another business to save rent
Refinance a business loan to get lower payments
Cut the number of people on staff who are salaried
How to reduce variable expenses
Lowering your business’s variable expenses is another effective way to increase cash flow, but it also takes considerable strategy—and some trial and error. You have to make sure you’re not cutting expenses that directly impact the quality of your offerings. To strike the right balance, start by sorting your variable expenses into three categories:
Expenses that directly impact business revenue, such as inventory
Expenses that indirectly impact revenue, such as customer management software
Expenses that don’t impact revenue at all, such as office kitchen snacks
You probably don’t want to reduce the cost of expenses in category one, but you may be able to lower expenses in category two by a quarter and expenses in category three by half or more. Here are a few strategies for reducing variable costs:
Switch to free business software providers
Negotiate with your vendors about discounts on bulk orders
Look for money leaks within your business
Outsource administrative tasks or small jobs
Understanding your expenses
Your expenses are the heart of your business financials. Knowing how much money you spend per month on fixed and variable costs is essential to staying operational and profitable. Whether you want to create a tighter budget, build up a cash reserve, or increase your cash flow, getting a more detailed picture of your fixed and variable expenses can help.
Fundbox and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.