Fixed and Variable Expenses: What Do These Terms Mean?

Fixed vs. variable expenses

Fixed and variable expenses are part of your general ledger, which is how businesses keep track of their finances. A fixed expense means one that doesn’t change — it’s a set amount you pay on a recurring basis. Meanwhile, a variable expense changes due to how many units you produce and sell and other factors. Both types of expenses can be direct or indirect costs.

Knowing how to distinguish between the two can help you create a budget, control costs and plan accordingly. [Are you looking for help with expense tracking? Check out our recommendations for the best small business accounting software.]

Here are some key differences between fixed costs and variable costs:

• Fixed expenses remain static over a set period of time; variable expenses fluctuate based on volume and other factors.
• Fixed expenses are not impacted by production output. For example, you make the same office lease payment every month regardless of how much work you do in that office. Variable expenses, however, increase or decrease based on your output because you use more raw goods and spend more on hourly labor to increase output.
• Fixed expenses are often time-related, such as your monthly office lease payment. Variable expenses are often volume-related, such as the amount of time your hourly employees work each week.

Variable expenses

A variable expense is a cost that changes depending on your production level. In other words, your sales volume directly impacts your variable expenses.

For example, let’s say you sell phone cases. Below is a chart explaining how those variable expenses would work. While the packaging cost per case remains the same, the total cost of packaging rises when production is higher. 

It’s critical to understand your total variable expenses from the start to see where you can potentially save money. Shaving the costs that go into selling each product makes a huge difference in your bottom line. 

Here are some more examples of variable expenses:

• Utilities, like electricity and water
• Credit card and bank fees charged for taking customer credit cards
• Hourly wages and direct labor
• Shipping costs
• Raw materials
• Sales commissions

Fixed expenses

Fixed costs are what most people refer to as overhead costs. These are the expenses you can’t reduce regardless of how much business you’re doing.

Indeed, your fixed costs may even increase over time. Rents go up, salaries increase and insurance premiums tend to rise. However, these costs are fixed in the sense that they don’t change based on your production volume. Whether you sell one phone case or a million, these costs remain the same. 

Here are some common examples of fixed expenses:

• Rent
• Car payments
• Insurance
• Salaries
• Interest expenses
• Property taxes
• Leased equipment
• Loans
• Depreciation

Mixed (semi-variable) expenses

A third category of expenses is a mixture of fixed and variable. Let’s say you’re paying $100 for web hosting each month, but one month you exceed your bandwidth limit and are hit with an extra $20 fee. You’ll pay the fixed $100 no matter what, but the extra $20 is variable. Together, they make a mixed expense.

Another example would be if you have a salesperson working on base salary plus commission. The base salary for this employee is fixed, but the commission they earn on each sale is variable, as the commission amount depends on the number of sales made. Thus, the employee’s total pay is a mixed expense.

How to budget for fixed and variable expenses

Planning ahead for fixed and variable expenses is an important part of business and cash flow strategy. Budgeting for fixed expenses is generally straightforward. Rent, salaries and other payroll costs and baseline utilities are the first things you should enter in your budget. Longtime businesses probably know what to expect for these expenses. If you are starting a business, be sure to plan carefully for all potential fixed expenses.

Budgeting for variable expenses can be more challenging, especially in times of high inflation. “For variable expenses, like material costs or marketing spend, it’ll be easier to look at historical data (if available) and leave room for fluctuations,” said Mark Wilkinson, co-founder and chief financial officer at TileCloud. He recommended leaving a buffer for unexpected spikes in variable costs. Yehuda Tropper, CEO at Beca Life, added, “For variable expenses, we use a rolling average from the past three to six months, plus a 15 to 20 percent buffer to account for fluctuations.”

Some costs can be dealt with as fixed or variable expenses, depending on management decisions. This can significantly affect cash flow. “For instance, large, fixed expenses like equipment purchases can be converted into variable expenses through leasing,” said Jay Jung, founder and managing partner at Embarc Advisors. “Similarly, outsourcing certain functions can transform chunky fixed costs into manageable, scalable variable expenses, preserving cash flow and providing greater flexibility.”

How to save on variable and fixed costs

One way to increase your business’s profitability is to find ways to reduce operational costs. This often includes cutting back on large, fixed costs but it can also entail streamlining variable costs. 

Saving on variable costs

Variable costs must be controlled to preserve profitability. “For variable expenses, we implement strict approval processes and regularly review supplier relationships,” said Tropper. Here are some other ways to save on variable costs:

• Search for ways to lower your utility bills: Use less electricity and water whenever possible and opt for a cheaper internet or phone plan that still meets your company’s needs as a business. Monitor how much money you spend on utilities each month, which will reveal areas of waste and motivate your organization to be more energy efficient. [See our picks for the best business internet service providers, many of which offer bundle deals for cost savings.]
• Maintain minimum balances in bank accounts to avoid fees: Many banks require a minimum amount of money to be kept in specific accounts each month. Monitoring the amount in your accounts can help avoid unnecessary fees.
• Pay credit card bills on time and in full: Late fees and interest charges quickly become expensive — and they’re avoidable if you keep an organized payment schedule and budget for them.
• Streamline packaging and shipping: One way to do this is to adopt more eco-friendly packaging, which can save money. By optimizing packaging and shipping processes, you can reduce the costs of each. Find ways to use less equipment, tailor the sizes of packages to the product and consolidate shipments as much as possible.
• Reduce overtime when possible: Overtime costs can eat up the gross profit on each unit sold quickly. Tropper said that her business reduces overtime costs during peak periods by cross-training staff on different tasks.

Saving on fixed costs

Controlling your fixed costs generally requires good planning. “Usually if you want to cut fixed costs, it requires some big decisions, like downsizing,” said Egor Belenkov, CEO of Kitcast. “But you can also optimize your work and reduce your fixed costs simultaneously.” Here are some possible ways to save on fixed costs:

• Renegotiate your rent or find a more affordable office space: If you want to lower your monthly rent, reach out to your landlord to negotiate a lower cost in exchange for a longer lease or a lease extension. If your current location is larger than you need or the cost is breaking the bank, look to downsize or move to a more affordable property.
• Find ways to reduce business insurance premiums: You may be able to do this by installing features in your office that eliminate or lower certain risks. For instance, if you pay for theft protection, you could install a security system instead of paying that ongoing insurance cost. You could also negotiate lower premiums if you have a good customer history with your insurance company. [Related article: Ways to Save Money on Business Insurance]
• Lower your monthly lease or loan payments: It doesn’t hurt to ask for lower monthly payments on these agreements. Leasing companies and banks are often willing to extend your payments over a longer period of time to decrease the amount you must pay each month. While this might increase the interest rate, it can lower your costs until you’re in a more financially comfortable place.
• Only have a few managerial positions: Rather than hiring many managers and paying all of them a high salary, consider retaining only the best and compensating them well. You may be able to do this by merging similar departments under one manager. 
• Switch to remote work: Belenkov suggests you may reduce fixed costs if you switch to remote work, reducing or eliminating office rent.

How fixed and variable expenses impact your breakeven point

Knowing your fixed and variable expenses is crucial to calculating your breakeven point – the amount you must sell to avoid operating at a loss. You can also use fixed and variable expenses to determine how much you must sell to make a certain net profit. “Budgeting [for fixed and variable expenses] is essential because it helps identify businesses’ breakeven points and helps them set pricing and determine the minimum level of production needed to avoid a loss,” said Paul Wnek, founder, CEO and principal solutions architect at ExpandAP. 

For example, say you produce widgets with the following annual revenue and cost amounts:

Calculate the number of widgets you must sell to break even as follows:

Fixed costs / (Sales price per unit – variable costs per unit) = Breakeven number of units sold

In this case, $100,000 / (12 – 5) = 14,286 units. In other words, you must sell 14,286 units before you start to make a profit.

You can try different scenarios with the breakeven unit formula. For example, you may decide you could sell more widgets at a lower price. Before you reduce prices, use the breakeven point calculations to determine if that will help or hurt your bottom line.

You can also use the breakeven point with fixed and variable cost information to determine how much product you must sell to make a certain profit. Calculate the number of widgets you must sell to make a given profit as follows:

(Fixed costs + Profit target) / (Sales price per unit – variable costs per unit) = Number of unit sales to reach profit target

The importance of understanding fixed and variable expenses

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.

Sometimes you may have to decide between paying fixed or variable costs. There are benefits and risks associated with each. For example, if you’re an online retailer, you might choose to outsource each sale to a third party so that you don’t need to handle shipping. It could work in your favor to pay the third party with variable expenses — meaning they’ll get a cut of each sale — so you don’t need to pay them if you don’t sell anything.

However, there could come a time when your sales are so high that these variable costs total a significant amount of money. At that point, you’ll need to consider whether it would save you money to invest in the fixed expense of hiring staff to handle shipping in-house.

Making good decisions related to fixed and variable expenses can lead to fruitful negotiations and better profit margins. You should continuously review fixed and variable expenses as part of managing your company and helping to maximize your company’s potential as it grows and prospers.

Sally Herigstad, Jennifer Dublino and Mike Berner contributed to this article.