Expense management might be the least exciting part of owning and running your small business. After all, seeing the money come in is much more satisfying than watching it go out in the form of expenses.
Exciting or not, expense management is a key part of accounting and is crucial to your business’s financial health and profitability. And part of expense management is knowing how the different kinds of expenses in your business impact your cash flow and profitability.
There is more to understanding your business’s expenses than simply monitoring the amount of money you pay out each month. 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 or adjustments you make to your business activity.
The expenses that stay the same regardless of your sales or business activity can have the most significant impact on your cash flow and budget. These are called fixed expenses, and we’ll take a closer look at them here.
What Are Fixed Expenses?
Fixed expenses are a type of overhead expense. Overhead expenses are, simply put, 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.
Fixed expenses are the overhead expenses that don’t change from month to month. If a fixed expense does change, it typically happens on an annual basis and during a renewal period. Sometimes, they remain the same for several years.
Some common examples of fixed expenses include:
- Some utilities, especially if you enter into a fixed pricing arrangement with the utility company to “normalize” your payments throughout the year
- Depreciation and amortization
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 impact your business’s profitability, and the amounts typically don’t change over the lifespan of the asset. In other words, the 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.
For example, let’s say you own a greenhouse. You employ a horticulturist and pay her a salary of $40,000 per year. Your insurance expenses are $1,000 per month. And, to give your customers the best shopping experience, you contract with a local guitarist to perform every weekend during the gardening season. You pay the guitarist $175 for each day he plays.
Planting season typically starts the first weekend of April. But this year, historic cold temperatures hit, and you even have some snow on the ground on what is supposed to be your opening day.
You will still have to pay your insurance expense, and your horticulturist will still show up to work because a few die-hard gardeners will bundle up and come out to shop for plants regardless of what the weather does. However, you call the guitarist and ask him to wait until the second weekend of the month to come perform (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.
What About Variable Expenses?
A business with high fixed expenses can quickly find itself in trouble if income decreases drastically and doesn’t improve quickly. But variable expenses can be just as tricky to manage.
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 reduced your overhead expenses for that first weekend of the month. This would have been a quick adjustment to make in response to your business revenue, and it 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 actually using more water than normal, because you have more plants to care for since fewer people bought them during the first weekend of the month.
Typically, variable expenses can be reduced when your business experiences a loss of revenue or a decrease in activity, but not always. Sometimes decreased sales can result in higher variable expenses, especially when you have to pay higher prices to maintain your product. And some variable expenses are unpredictable and don’t correlate to your revenue or other business activity at all.
Legal expenses are a good example of variable expenses that are not related to sales or business activity. Legal issues can pop up at any time, and usually they happen with little notice or warning. They typically don’t coincide with the ebb and flow of your business’s sales, and increasing or decreasing other business activities—like advertising—don’t always influence legal expenses.
You can see how variable expenses can be hard to predict. But even though they are unpredictable, they are usually easier to adjust than fixed expenses.
Fixed Expenses and Budgeting
Creating and maintaining a business budget is one of the most effective ways to manage your business’s expenses. Fixed expenses are by far the easiest expenses to budget for, because you know they will be the same every month.
When you are creating your business’s budget, start by totaling up 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 to set aside a percentage of your income each month to build a reserve of cash to help you weather leaner sales months. You might be tempted to reinvest everything you can to help you grow your business, but creating and maintaining a cash reserve is just as important as investing in business growth. Using this strategy to build a reserve of three-six months’ worth of fixed expenses will help you have 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.
The Bottom Line
Fixed expenses are the easiest expenses to predict and plan for in your business. They are also some of the hardest expenses to adjust. Planning ahead to ensure you always have a reserve of cash to cover three to six months’ worth of fixed expenses will help you during months when sales are down or cash is tight.
Variable expenses respond to changes in sales or other business activity quicker than fixed expenses do, but this doesn’t necessarily make them “better” than fixed expenses. Variable expenses can be difficult to budget, and they are often influenced by unpredictable events. Strive 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 mix for your business. They can also help you mitigate the uncertainty that accompanies variable—and even fixed—expenses.
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. If your fixed expenses are too high, speak with your accountant, bookkeeper, or banker to brainstorm ways to reduce them.