The difference between fixed and variable costs
Fixed costs create a consistent baseline of financial obligations you must meet regardless of business activity. If you have high fixed costs, you have high operating leverage, meaning you can increase profitability with additional sales but are at greater risk during revenue downturns. To effectively manage these risks, it’s important to set a monthly budget for fixed expenses, ensuring that you meet your financial obligations without compromising growth. Fixed costs remain constant regardless of production or sales volume. While this predictability is useful for fixed vs variable expenses budgeting, fixed costs can pressure cash flow during periods of low revenue.
Recognizing the difference between fixed and variable expenses helps you make smarter decisions every single month. It’s one of those simple shifts that leads to real, lasting change. Now that you’ve got an understanding of how the two expense categories differ, let’s explore some strategies for budgeting for fixed and variable expenses.
Next Steps: Build a Smarter, Simpler Budget
Some variable expenses are vital, like groceries, and others, like concert tickets, are optional. Unlike fixed expenses, you can control variable costs to allow for more profits. Variable expenses used in this analysis can include the raw materials or inventory involved in the production, whereas fixed costs can include rent for the production plant.
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- You might normally treat yourself to one muffin each week, spending $4 on average per month, but some months you might indulge more and spend $10 or $15.
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- Learn how to build, read, and use financial statements for your business so you can make more informed decisions.
- Fixed costs stay the same no matter how many sales you make, while your total variable cost increases with sales volume.
- Once fixed expenses are covered, you can allocate the remaining funds for variable and discretionary spending.
Fixed expenses stay the same regardless of business activity, like rent or loan payments, making them predictable for budgeting. Developing a new production process can help cut down on variable costs, which may include adopting new or improved technological processes or machinery. However, if the company doesn’t produce any units, it won’t have any variable costs for producing the mugs.
Balancing Fixed and Variable Costs for Healthy Cash Flow
By the end, you’ll have a clear framework to analyze expenses, improve financial health, and make data-driven decisions. Our revenue analytics software is designed to help subscription businesses like yours track vital metrics, offering you a clear, up-to-date view of your financial performance. Learn how to build, read, and use financial statements for your business so you can make more informed decisions. Our intuitive software automates the busywork with powerful tools and features designed to help you simplify your financial management and make informed business decisions.
On the other hand, if you have high variable costs, you can adapt more easily to changes in demand. Once you know how to identify fixed and variable expenses, you can develop strategies to prevent overspending during low-revenue periods. Mastering the balance between fixed and variable costs is key to managing a successful business. By understanding these cost categories and how they impact your financials, you can make more informed decisions about pricing, budgeting, and cost control.
Fixed Costs: Deep Dive
For instance, if you get sick, then a doctor visit may be a necessity that you need to cover. On the other hand, a discretionary expense means anything you budget money for or spend money on that you don’t necessarily need. Saving can also be considered a fixed expense if you’re budgeting for it regularly.
- The more items your business sells and ships to customers, the higher your shipping expense.
- Both fixed and variable expenses need to be accounted for to provide a complete picture of your business’s overall financial health and profitability.
- While sunk costs may be considered fixed costs, not all fixed costs are considered sunk.
Fixed expenses are costs that usually stay the same over time, meaning they are regularly occurring and generally don’t change in dollar amount. Unlike variable expenses, fixed ones tend to be predictable and therefore easier to plan for. Variable costs change directly in relation to the output of a business, so when there is no output, there are no variable costs. A good example of variable costs is the operational expenses that increase or decrease based on the business activity. If a business grows, so will its expenses such as utility bills for electricity, gas, or water. When it comes to fixed and variable costs, a clear understanding of each is essential for identifying the correct price level for goods and services.
Variable Costs Explained
A common fixed cost situation for a business is a building that must be heated and air conditioned, even if no one is currently occupying it. Fixed costs remain constant regardless of your production or sales volume. Whether you produce ten units or 10,000 units, these expenses stay the same. This guide explains the difference between fixed and variable costs, provides examples of each, and covers how to use this knowledge to reach your business goals.
Saving on fixed and variable costs
Even if fixed expenses, such as rent and car payments, stay the same, variable expenses can change, sometimes rapidly. You can calculate the variable cost for a product by dividing the total variable expenses by the number of units for sale. To determine the fixed cost per unit, divide the total fixed cost by the number of units for sale. 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.
Let’s look at an example of fixed and variable expenses to see how they work in the real world. As your business grows, monitoring these costs ensures your profits grow proportionally. For example, if raw material costs increase unexpectedly, your profit margins might shrink unless you increase your price. Other fixed expenses, like your mortgage payment, can be trickier to change or lower. If interest rates are lower than when you initially took out your mortgage, you may be able to refinance to a better rate.
She’s been writing about personal finance since 2014, and her work has appeared in numerous publications online. Beyond banking, her expertise covers credit and debt, student loans, investing, home buying, insurance and small business. It’s important not only that you have a budget but also that you make an effort to live your budget. This means that you go beyond simply planning out your budget and commit to the spending rules you’ve laid down for yourself. Living your budget may mean rethinking wants versus needs to avoid overspending.
Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design.