In every business budget, you’ll find certain expenses that can change dramatically from month to month. These are variable expenses, and they make up a large portion of small business spending (unlike fixed costs, which remain the same each month). The fluctuating amounts behind variable expenses makes planning for them in your business budget hard—but not impossible.
Budgeting for variable expenses isn’t an exact science, but there are some tricks you can use to make sure they don’t derail your business’s finances. Before we get into the how-tos, though, let’s get a solid variable expenses definition in place and clarify the difference between the three types of expenses that impact your business budget: variable expenses, discretionary expenses, and fixed costs.
What Is a Variable Expense?
Variable expenses—also known as variable costs—are expenses that change depending on how much you use a product or service.
By comparison, fixed costs stay the same over an extended period of time. And, while discretionary expenses change depending on use, too, they are the extras you enjoy but are not necessary to run your business.
Examples of Each Type of Business Expense
To help you further understand the different between a variable expense and other types of business expenses, let’s look at a few examples. This will help clarify what fixed costs are, the variable expenses definition, and allow you to understand discretionary expenses, too:
- Insurance payments
- Most loan payments
- Dues and subscriptions
- Annual salaries
- Utilities payments
- Automobile usage expenses, like fuel and maintenance
- Office supplies
- Professional services charged by the hour
- Payroll for hourly employees
- Most meals and entertainment expenses
- Client gifts
- Staff parties and bonuses
So, simply put, the variable expenses definition is costs that change; a fixed cost stays the same over a long period of time; and you can think of discretionary expenditures as your “nice-to-haves.”
Variable Expenses Are More Than Operating Costs
One thing to note is that the lists above focuses on operating costs, but variable expenses usually affect your cost of goods sold more than anything. If your business produces a product, you need to be aware of the variable costs of production.
Why is this important? Your variable costs of production have a direct impact on your break-even point. Your business’s break-even point is how much money you need to make in order to cover your costs for the month. Which, as a business owner, you know how important it is to make more than you spend.
How Do Variable Expenses Affect My Business Budget?
Now that we have a good understanding of the variable expenses definition and the other types of business expenses, let’s take a look at how variable expenses affect your business budget.
The nice thing about variable expenses is that you can easily adjust your variable costs of production in response to a downturn in sales or production… actually, they usually adjust themselves, because when production slows, you stop incurring those costs. Overhead variable costs—like those listed above—are harder to adjust. That also means they are harder to plan for in your budget.
Let’s look at a variable expenses example we can all relate to: electricity costs. Depending on where you live and your options for heating sources, your electric bill might range from around $100/month in the milder months of the year to upward $300/month in the harshest parts of summer and winter.
Changing climate conditions also affect these already variable expenses. You could have a year or two of very mild winter weather, only to be struck out of the blue by a winter that doesn’t end.
Although you can take steps—like using a smart thermostat—to reduce the amount you pay for electricity, this variable expense is largely out of your control. This is frustrating, since an unexpectedly large electric bill can wreak havoc on your budget, especially if it coincides with a revenue slump. (And if you’re manufacturing a temperature-sensitive good, for instance, it’s not like you can just go without heat or cooling to save cash—and we’re sure your workers would agree, no matter what kind of work you do.)
How do you fix this?
5 Ways to Reduce the Impact of Variable Expenses on Your Budget
In the example above, sometimes you can reduce the impact of variable expenses by asking your service provider to let you pay a fixed amount each month. (Deceptively simple, but really helpful.) This fixed amount is based on the average of your bills for the previous 12 months. Many utilities companies offer this option to help their customers budget, but an average payment option won’t be available for every variable expense in your budget.
You can still use this average payment concept to reduce the impact of variable expenses on your budget, though. Here’s how:
- Determine the annual average for each variable expense in your budget. When you’re determining the annual average for a variable expense, avoid the temptation to only look at the past 12 months. Take the time to review the average of three years’ worth of variable expenses. This will help you account for anomalies that may impact your average for an expense. Unless you have taken steps to permanently reduce a variable expense, err on the side of caution and use the highest average amount.
- Add a buffer. After you have determined the average for each variable expense, add a buffer to it. A buffer of 3% to 5% should be more than enough to cover price increases and most anomalies that will result in an outlier year for the expense. If you want to be really cautious—and if your budget can handle it—build in a buffer of 10%.
- Track your actual spending. Each month, compare your actual expenditure for each variable expense to the budgeted amount. Note if you were over-budget or-under budget for each expense category. If you use business accounting software, look for a Profit and Loss to Budget Comparison Report. This report can usually be customized to do the dollar amount increase or decrease calculation for you, so you can see at a glance if you were over or under budget without having to do the math yourself.
- Set up a savings account for variable expenses. This is the crucial step in this process. Each month you are under-budget for a variable expense, move the excess into your business savings account for variable expenses. This will create a reserve you can draw from during months when your expenses are higher than usual. For example, let’s say your electric bill averages $375/month. You’re having a mild winter, so your actual electric bill was $355 in January and $325 in February. March comes in like a lion, though, and a week of unexpected below-freezing temperatures results in a March electric bill of $445, when the bill for March is usually closer to $245. Most business owners budget their variable expenses based on the actual expense from the previous year. But because you have budgeted an average of $375/month for electricity ($130 more than your usual electric bill for March) and because you moved the excess money budgeted for your electric bill in January ($20) and February ($50) into your savings account for variable expenses, you have enough money for the unexpectedly high electric bill for the month of March. If you had only budgeted the $245 for a “normal” electric bill for March, you would have had to quickly come up with an extra $200. For a very small business, or a business experiencing a drop in revenue, this can be very difficult to do.
- Reassess your variable expenses annually. You might be tempted to use the same variable expenses projections in your budget each year, especially if you have saved a decent amount in your variable expenses savings account. Avoid this temptation. You should reassess your variable expenses each year. Especially in expense categories where you have a bit more control than you do with utilities—like automobile usage expenses—opportunities exist to make strategic changes to control the expenses.
Helpful Tip: Capturing All Variable Expenses in Your Budget
Most budget templates are designed to match a typical business’s chart of accounts. This means fixed costs, variable expenses, and discretionary expenses are scattered throughout the template. This layout makes it really easy to compare your actual numbers to your budgeted numbers (remember the Profit and Loss to Budget Comparison Report mentioned earlier?), but it also makes it easy to “gloss over” your variable and discretionary expenses when you are setting your budget numbers.
When you’re first putting together your business budget, start by listing out your expenses by type (fixed, variable, and discretionary). After you have determined the appropriate amount for each expense, you can plug those amounts into your budget template so it is ready to use to compare your budget to actual numbers each month.
In short, the best way make sure that you’re prepared to mitigate the impact of variable expenses boils down to paying attention to the costs of those expenses in the past, and preparing yourself with a buffer or some savings to take care of them in the future. Averages are good indicators of where you might land so you’re not surprised—and keep paying attention so you’re not shocked by changes.
Reducing Actual Variable Expenses
Above we focused on reducing variable expenses’ impact on your budget, but what if you’re in a place where you need to reduce your actual variable expenses? If your business struggles with the lack of predictability, or you need to cut costs, you may be looking to reduce your overall variable expenses.
While we used the example of electricity above, you’ll find most of your variable costs are around the actual production of your product. It’s about the labor and the materials that go into it, and if you need to cut costs, you need to analyze this process and see if there are ways you can produce similar output even after cost-effective changes are made to this process. Examples include:
- Labor. Is there anything that can be automated or outsourced that wouldn’t affect quality? Can you increase the efficiency of your workforce, getting more output, by providing them with certain tools or services?
- Materials. Are you using the most cost-effective materials? Can you buy in bulk? If you bought better materials, would you have less issues with your product down the road?
- Assessing Your Product or Service. Many companies offer different products and services. You could be selling things as a package, but it’s only a portion of the package that is really generating revenue. Should you be eliminating certain features? Is there a way you could deliver your product or service faster?
Remember, just because something has always been done a certain way doesn’t mean it’s the right way. As businesses grow, you can become overwhelmed and don’t usually have time to tear apart your current systems and processes as much as you like. But, given how much the market can change and costs can evolve, doing this might really help your business identify areas to save on variable expenses.
Variable Expenses Affect Your Budget… but They Shouldn’t Destroy It
It’s frustrating to form a plan, only to have circumstances beyond your control throw that plan off course. This is one of the reasons why many small business owners avoid budgeting altogether. Especially if most of your business expenses are variable—as is often the case with very small businesses—trying to come up with an accurate budget can seem impossible.
Now that you have a clear variable expenses definition, with a little bit of planning, even the most volatile of your variable expenses can be accounted for in your budget with ease. Building a buffer in a business savings account to carry you through the months when your variable expenses are higher than projected will keep your budget on track and protect your cash flow. Reassessing your budget for variable expenses annually will help you identify areas for savings and other improvements.