What is a fixed expense?

Fixed expenses are those that don’t change according to the activities of the business. For instance, a business’ mortgage payment or the costs of employee benefits are fixed expenses that won’t change even if the business increases its revenue. There are several types of fixed expenses a business can have, and these include costs for things like:

• Office rent or property mortgage
• Utility payments
• Employee payroll

It’s important to note that fixed expenses typically don’t change, but there’s a range of activity that can account for varying changes in expenses. An example of this would be the business’ employee payroll. If a business increases its profits by a large percentage, then the business might change the payroll to reflect a salary increase for its employees.

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What is a variable expense?

Variable expenses, on the other hand, are those that change frequently and are connected to the activities of the organization. For instance, variable expenses would be the cost of materials to manufacture a product, the cost of travel to provide services to clients and other changing expenses related to business operations. Variable expenses could include:

• Employee commission: Commissioned salaries can change, especially sales commission, depending on the cash flow of the business.
• Costs of production: The costs of manufacturing supplies, equipment maintenance and direct materials can all fluctuate based on business activities.
• Travel expenses: Employees who travel for business may incur varying expenses related to the business’s activities.

A business’ variable expenses can include additional costs related to its activities, such as fees attached to customer credit card payments or the total cost of goods sold.

Importance of identifying expenses accurately

As you grow your business, you will need to identify fixed and variable expenses to analyze your break-even point. This means you can calculate the most profitable price points for your business’s products or services so that you can determine where your business’ revenue will equal its total costs. This is helpful because it gives you insight into your organization’s profit margin or the rate at which you need to sell products and services to bring in a profit.

Another important reason for correctly identifying your fixed and variable expenses is so you can take advantage of tax deductions. Depending on the type of expense, you may be able to deduct these costs from your taxes, resulting in owing less when you file. Some deductible expenses — both variable and fixed — may include employee wages, advertising costs and business travel expenses.

Calculating fixed versus variable expenses

To calculate your business’s fixed expenses, combine the total costs you expect your organization to be responsible for. For instance, you can add up the total costs of a mortgage, employee payroll, licenses and permits, insurance or loan payments.

Calculating your variable expenses is a little more complex, as it requires you to analyze your break-even point. Understanding this relationship is useful because it provides insight into how to create revenue growth after meeting your break-even point.

To calculate your variable costs, add the total costs you expect the business to incur due to production or providing services. For example, if the costs to manufacture a product equal $75 per item, this is your total cost to produce the product. Now, subtract this amount from the price you sell the item for. If the product sells for $125, this equals a gross profit of $50 per product sold.

To find the break-even point, divide the total amount of fixed expenses by the gross profit. For example, if your total fixed expenses are $100,000, you calculate your break-even point by dividing ($100,000) / ($50) to get $2,000. This is the amount you need to reach to cover all your business’ fixed expenses.