Fixed expenses are those expenses that stay the same regardless of your sales or business activity and can have a significant impact on your cash flow and budget. Expenses like rent or mortgage, insurance, salaries, and some utilities fall into the category of fixed expenses.
Expense management might be the least exciting part of owning and running your small business, but exciting or not, it’s a key part of accounting and is crucial to your business’s financial health and profitability. After all, seeing the money come in is much more satisfying than watching it go out in the form of expenses.
Part of expense management is knowing how the different kinds of expenses in your business impact your cash flow and profitability. Understanding your business’s expenses isn’t simply monitoring the amount of money you pay out each month, but also noticing the type of expenses.
Certain expenses—like cost of goods sold and variable expenses—change depending on your sales volume, total revenue, or other business activities. Other expenses stay the same, regardless of whether you have a spectacularly good—or spectacularly bad—sales month, and those are your fixed expenses. We’ll take a closer look at fixed expenses here.
Fixed expenses are a type of overhead expense, which is essentially the cost of operating your business. These expenses differ from direct costs—often called cost of goods sold—because they don’t go into the production of your product or the delivery of your service.
While fixed expenses typically don’t change, if a fixed expense does change, it typically happens on an annual basis and during a renewal period. More commonly, they remain the same for several years.
Some fixed expense examples include:
You might be surprised to see depreciation and amortization listed as fixed expenses. Even though these expenses don’t directly impact your business’s cash flow, they are still considered fixed because they affect your business’s profitability, and the amounts typically don’t change over the lifespan of the asset.
In other words, your profit and loss statement will show the same amount for the depreciation expense (or amortization expense, if the asset is intangible) every month of the year, for every year of the useful life of the asset, until the asset is fully depreciated or removed from service.
Fixed expenses are the easiest to budget and plan for because you know they will be the same every month. But even though they are easy to budget for, they are also the hardest expenses to reduce in response to decreased sales or restricted cash flow.
In addition to the brief fixed expense examples in the section above, let’s walk through a hypothetical situation.
Let’s say you own a greenhouse and these are your projected expenses:
This April, historic cold temperatures hit, and snow is falling on what is supposed to be your opening day.
Still, you must pay your insurance and your horticulturist despite the cold weather. However, you call and reschedule the guitarist (he’s grateful because it’s hard to strum with frozen fingers).
Your insurance and payroll expenses are fixed. Even though your opening weekend went from a projected $20,000 to $10,000, you will still have to pay these expenses. The expense for the guitarist, though, is a variable expense. It responded quickly to the change in your sales.
Fixed expenses are typically “locked-in” by a contract or some other agreement. You have to pay them regardless of what happens in your business. If not planned and managed properly, fixed expenses can wreak havoc on your business during a downturn.
Fortunately, the weather improves by the middle of the second week of April, and you make up for the 50% dip in projected sales you took during the first weekend. If the cold spell had held on longer, your greenhouse could have experienced some financial hardship due to high fixed expenses.
Variable expenses are those that are ever-changing. A business will incur variable expenses if they’re buying from new vendors on a one-time basis, have frequently changing payroll obligations, and anything else that would cause varying monthly payments.
Some variable expenses are unpredictable and don’t correlate to your revenue or other business activity, like legal expenses, as they don’t coincide with the natural ebb and flow of your business. Because of that, managing variable expenses can be just as tricky as fixed expenses.
Variable expenses respond quicker to changes in sales or other business activity than fixed expenses do. Looking back at our greenhouse example, you could have chosen to pay your horticulturist an hourly wage rather than a salary. If you had, you could have asked her not to come in until the second weekend of April, and you would have had an immediate positive impact on your bottom line.
But now, let’s look at your water consumption. Because your business is seasonal, you don’t have a fixed pricing arrangement with the water district. You pay for the water you use. And, in the case of the April cold snap, you are using more water than usual because you have more plants to care for since fewer people bought them during the first weekend of the month.
Variable expenses can be reduced when your business experiences a loss of revenue or a decrease in activity, but sometimes decreased sales can result in higher variable expenses, especially when you have to pay higher prices to maintain your product.
Variable expenses can be hard to predict but have the slight advantage of being easier to adjust than fixed expenses.
You can follow this simple process to calculate your business’s total fixed expenses:
In addition to your total fixed expenses, it’s also helpful to calculate average fixed cost.
Average fixed cost shows your fixed cost per unit. Essentially, it establishes how much it costs to produce your product before variable expenses enter the equation.
Use the following formula to calculate your average fixed cost:
Average Fixed Cost = Total Fixed Cost / Number of Units Made
Continuing with our greenhouse example, let’s say you want to know the average fixed cost to produce 5,000 flower pots. Here are your fixed monthly costs:
Next, let’s plug the total fixed cost into the average fixed cost formula.
Flower Pot Average Fixed Cost = $8,700 / 5,000 units
To produce a single flower pot, you must pay $1.74 in fixed costs.
Understanding your total fixed costs and the average fixed cost per unit can help you make more informed decisions that affect your bottom line.
Learning how to find and calculate your fixed expenses and average fixed costs makes it easier to create and maintain an accurate business budget.
After totaling your fixed expenses, compare this number with your sales projections. Are your total fixed expenses higher than your lowest projected sales month, or do you have months where you are projected to just break even? If so, consider ways to prevent this from becoming a problem.
One effective strategy to ensure your fixed expenses are always covered is setting aside a percentage of your monthly income to build a reserve of cash, which will help you weather leaner sales months. A reserve of three to six months’ worth of fixed expenses will encourage greater peace of mind.
This, in turn, will help you make more sound business decisions during periods of decreased sales or restricted cash flow—times that are typically very stressful and can result in snap decisions to improve things quickly.
Fixed expenses are the most straightforward expenses to predict and plan for in your business—and are also some of the hardest expenses to adjust. Planning ahead to ensure you always have a reserve of cash will help you during months when sales are down, or cash is tight.
Even though fixed expenses don’t change often, no expense is fixed forever. Rent amounts change, mortgages can be refinanced, insurance coverage may be modified, and loans will eventually be paid off.
The best approach is to have a healthy mix of both fixed and variable expenses in your business budget. Your accountant or bookkeeper can help you determine the best combination for your business. They can also help you mitigate the uncertainty that accompanies variable—and even fixed—expenses.
Billie Anne Grigg is a contributing writer for Fundera.
Billie Anne has been a bookkeeper since before the turn of the century. She is a QuickBooks Online ProAdvisor, LivePlan Expert Advisor, FreshBooks Certified Beancounter, and a Mastery Level Certified Profit First Professional. She is also a guide for the Profit First Professionals organization.
Billie Anne started Pocket Protector Bookkeeping in 2012 to provide an excellent virtual bookkeeping and managerial accounting solution for small businesses that cannot yet justify employing a full-time, in-house bookkeeping staff.