Fixed vs variable expenses: Definition and key differences

If you’ve ever taken a look at your company’s income statement, you’ll have noticed that your expenditure is broken down into two distinct categories:

1. Fixed expenses 
2. Variable expenses

What exactly is the difference between fixed expenses and variable expenses? What kinds of business spending fall into each category? And what ramifications does each type of business expense have for budgeting and cash flow?

In this article, we’ll provide answers to all of those questions.

We’ll discuss what fixed and variable expenses are, provide common examples of each, and explore how the two types of business spending are treated in your company’s financial statements.

What Is a fixed expense?

Fixed expenses are business costs that remain constant and stable over time, regardless of the level of the goods or services your business produces and sells.

Fixed costs don’t fluctuate with activity levels.

Rent, for instance, is a typical example of a fixed expense. You don’t pay more rent when production levels go up, and you certainly don’t get to pay less when business is slow!

Examples of fixed expenses 

Businesses have many fixed expenses to consider.

Here are just a few of the most common examples:

• Rent for your office, factory, and retail branches 
• Lease payments for equipment, property, or vehicles
• Wages for full-time employees with salaried positions
• Premiums for business insurance, such as property or health insurance
• Loan repayments on property mortgages, equipment financing, and general business loans 
• Property taxes on business-owned property
• Depreciation on capital assets such as equipment and vehicles
• Utility minimum charges that remain constant regardless of usage
• Software subscriptions that are paid monthly, quarterly, or annually 
• Fixed contracts, such as agreements for building maintenance and security services 
• License and permits, such as annual fees that are required to continue legal business operations

What Is a variable expense?

A variable expense is a business cost that can change depending on the level of business activity.

When your business produces more of the goods or services it sells, variable expenses increase, and vice versa.

Utilities bills are a classic example. When operating a manufacturing facility, increased production means more electricity is consumed, driving up your bill for that utility.

Examples of variable expenses 

Some of the most common examples of variable expenses that businesses incur include:

• Raw materials that are necessary inputs to the goods you producer
• Sales commissions paid to sales staff that increase with the number of sales made
• Utilities such as gas, water, and electric bills that are charged based on consumption
• Shipping and freight costs associated with receiving raw materials or shipping completed goods
• Packaging supplies that vary with the number of products sold
• Production supplies such as machine parts or cleaning supplies which vary based on production output
• Advertising and marketing costs which may increase during peak season or around new product launches 
• Contract labor, which changes based on how much work your company has available 
• Repair and maintenance costs which fluctuate based on production levels
• Hourly wages to part-time or hourly employees that may vary depending on how busy your company is
• Office consumables such as pens and ink that change with business activity levels
• Fuel costs that vary with usage
• Credit card processing fees which increase or decrease depending on the number and size of transactions your business processes 

Difference between variable vs fixed costs

Variable costs are business expenses that fluctuate when production levels rise and fall. When you produce more of the goods or services that your business sells, variable costs go up, and vice versa.

Fixed costs are the opposite.

Fixed costs will stay the same regardless of business output. No matter whether you produce zero widgets, 100 widgets, or 10,000 widgets, you’ll pay the same amount for that expense.

Loan repayments, for instance, are a fixed cost. It doesn’t matter whether your business has a strong or slow month; you still have to make that loan repayment based on your agreement with the lender.

Something like shipping, however, is a variable cost. The more items your business sells and ships to customers, the higher your shipping expense.

Some business expenses can have elements that fall into either camp.

For example, you might have a software subscription that you pay a fixed amount for monthly. That would be a fixed cost. But if you also buy an add-on module that’s usage-based — email send credits, for example — that portion of your bill would be considered a variable cost.

Fixed vs. variable costs accounting 

Since fixed and variable costs are fundamentally different expense categories, it's no surprise that they receive different treatments in accounting.

Here are a few of the key differences:

• Allocation: Variable costs are recorded as they are incurred, matching them with the revenue they generate. Fixed costs are more typically spread evenly over the period they cover. For example, rent would be recorded as a monthly expense, even if the payment is made on an annual basis.
• Impact on profitability. Variable costs increase with production but remain constant on a per-unit basis. Fixed costs, being fixed, are spread over more units as production increases. This reduces the cost per unit, driving up overall profitability.
• Financial reporting. Fixed costs are reported on the income statement as operating expenses. They impact the company’s net income. Variable costs, on the other hand, are recorded under the costs of goods sold (COGS) section. They impact the business’s gross profit.

Fixed and variable costs budgeting 

One of the most important distinctions to understand when looking at the difference between fixed and variable expenses is how each impacts budgeting, cash flow, and profitability.

Impacts on budgeting and cash flow

From a budgeting standpoint, fixed costs are easier to account for and prepare for since they’re 100% predictable. They make budgeting easy. But there’s a drawback:

You still have to pay your fixed costs even if revenue drops.

This can be a huge problem for cash flow, especially in seasonal industries where cash flow can be significantly less in the low season, but fixed costs still need to be serviced. 

The opposite is true of budgeting variable expenses.

They are generally more difficult to budget for as they rise with production levels, and these levels aren’t always easy to predict.

Yes, you can use historical seasonality and current growth trends to predict production levels, but there is always a margin for error.

When it comes to cash flow, variable expenses can be a double-edged sword.

The good news is that if revenue and production drop, so too do your variable expenses. If you’re earning less but you also have to pay less, it’s not a giant problem for cash flow.

The downside is that many variable costs need to be paid in advance of revenue. You might, for example, need to bear upfront all of the costs associated with producing a large shipment of goods despite not having yet been paid by your customer.

Impacts on budgeting and profitability

Fixed and variable expenses impact profitability in very different ways.

Variable costs directly impact the gross margin. The lower your variable costs, the higher your margins. By reducing variable costs, you can directly enhance profitability.

Fixed costs work a little differently.

Since you pay the same amount each financial period for those expenses, higher production levels come with enhanced profitability.

That is, you pay the same amount, but you produce even more goods or services, meaning your per-unit price is lower.

Let’s illustrate with an example.

Say your company’s fixed costs total $5,000. You sell widgets for $50 each and have variable costs of $40 per unit.

You have to produce and sell 500 widgets to break even:

((500 x (50-40)) - 5000 = $0

Let’s take two months of sales. In January, you sold 1,000 units. In February, you sold 1,500 units.

In January, you made a total profit of $5,000. In February, your profit was $10,000. You made twice as much profit, but you only sold 50% more widgets.

That means, of course, that your per-unit margin looked different:

• January: $5,000 / 1,000 units = $5 profit per unit
• February: $10,000 / 1,500 units = $6.67 profit per unit

That’s how fixed costs can dramatically impact profitability. As production increases, so too does your per-unit profit margin.

Strategies for managing fixed and variable expenses 

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.

You’ll want to start with forecasting, which essentially involves estimating how much your different expenses will be. Here are some easy sources to start with.

• Contractual agreements that you have with vendors will make clear any upcoming fixed costs you have.
• Historical data analysis. Digging through your previous financial records is an easy way to calculate recurring fixed costs. But it can also be an effective way to understand what variable costs you’ve incurred in the past and use those to create predictive forecasts. 
• Identify cost drivers. By analyzing historical performance and tracking revenue growth alongside cost increases, you’ll be able to understand what activities drive costs up. Market conditions, for example, may be a cost driver, meaning you can use economic forecasts to estimate variable expenses.
• Review inflation expectations. Consider how inflation can impact costs. While fixed-term contracts may have locked-in price points, variable expenses can be highly subject to fluctuations related to inflation. It's worth speaking with core suppliers to find out about anticipated price increases.

From there, you’ll want to begin implementing strategies for reducing and optimizing expenses. Here are a few of our favorites:

• Brush up on your negotiation skills. Work on negotiating better prices with long-term vendors, especially at renewal. This can help you reduce both fixed and variable costs.
• Outsource non-core activities. By outsourcing certain non-core functions, such as IT, marketing, and payroll, you can reduce the need for permanent staff and potentially swap some fixed expenses for variable costs if that’s favorable for your organization. 
• Consolidate services. Look for opportunities to combine services, such as software subscriptions, utilities, and insurance policies. This will allow you to take advantage of bulk and package discounts.
• Implement energy-efficient solutions. For companies that have high fixed utility costs, investing in energy-efficient equipment can help reduce overall costs.
• Implement rolling forecasts. Using rolling forecasts to continuously update and refine your budget can help you understand how costs impact profitability. You can also use this information to be more agile with pricing changes to reflect market conditions or your ability to leverage economies of scale.

Get on top of fixed and variable expenses 

Differentiating between fixed and variable costs, and in particular understanding how they impact financial management is crucial for effective budgeting and business forecasting.

Of course, you can’t produce particularly effective budgets or forecasts without accurate and timely data.

That’s where BILL comes in.

BILL is the financial operations platform with dozens of powerful features built-in, from accounts payable automation to cash flow forecasting to business expense management.

Dive into BILL today and transform your expense management.