In 2021, 5.4 million entrepreneurs driven by high aspirations applied for business licenses — a soaring uptick compared to the 4.4 million new business applications sent in during 2020. Unfortunately, maintaining a successful business requires more than unmatched enthusiasm.
Keeping budgets tight and controlling cash flow set a foundation for small businesses in the early stages of development. Once production starts, your expenses will rise. These expenses are known as fixed expenses and variable expenses.
Each metric affects production costs, volume needs, and overall budgets. Familiarize yourself with fixed expenses and variable expenses with our detailed guide below.
What Are Fixed Expenses vs Variable Expenses?
There are two categories of expenses in business: fixed and variable.
Fixed costs remain the same. Variable costs can fluctuate throughout different periods. Both metrics depend on your company’s size and industry. When comparing fixed vs variable expenses on your income statement, you’ll see how fixed expenses remain idle compared to their counterpart.
Fixed expenses come to fruition during the implementation of all business decisions pre-production. Revenue and the output of COGS do not affect fixed expenses. An easy way to define a fixed expense is to imagine your business closing for a few months. Anything requiring payments during that period of time is a fixed expense.
Examples of fixed expenses:
- Rent payments
- Mortgage payments
- Health Insurance (for employees)
- Loan payments
Variable expenses begin once production starts. These costs rise and fall in tandem with business performance and production volume. What your company sells also contributes to the total amount of variable expenses.
Examples of variable expenses:
- Operational expenses
- Raw materials
- Repairs and maintenance
Operating costs can be variable or fixed. They all fall into the same financial category; the significant difference is if they are affected by production volume or not.
Fixed expenses would only change for the following reasons:
- A change in offices with a higher/lower rent
- Labor team expansion
- Price difference in materials (higher/lower prices)
- Tax bracket changes
The Importance Of Knowing Fixed And Variable Expenses
We talk about expense monitoring often, but each KPI and production cost showcases a company’s financial health and future when consistently viewed. Variable and fixed expenses affect your company's core: sales and production.
Here are three key reasons why you should closely monitor both types of expenses:
1. Price Setting & Production Efficiency
Setting prices for products or services rely on the month-to-month fixed and total variable expense. If you set a low price, you won’t be able to cover the money it takes to produce the goods or services. When determining the perfect price point to cover expenses, you’ll need to know the total variable costs of producing the product, your desired profit margin, and fixed costs.
Use the formula below:
Total variable cost ÷ (1 - gross profit margin as a decimal) =profitable price point
Company X has a total variable expense of $10 to make one faux succulent with a goal of a 25% profit margin. The price per succulent comes to $13.33 or rounded up to $13.50.
$10 ÷ (1 - .25) = $13.33
There is also a formula to calculate the precise volume needed to break even. It takes a few more steps and requires multiple price points.
Economy Of Scale
Production efficiency is what investors and founders want to see from their company. Consistent, well-made goods or services increase revenue and turn first-time customers into loyal ones. Reaching the economies of scale goal entails lowering costs while increasing production.
The high cost of production and limited or smaller production volume keeps prices high for smaller businesses. This is where higher production volume comes in. As production volume increases the price of production lowers because it is spread out over a larger number of goods.
As production volume ramps up, the goal is to lower the costs associated with production. Breaking even or increasing total revenue is a sign the company is going in the right direction.
2. Make Better Budget Decisions
Cash supports all four corners of your business. The misuse of money is often the nail in the coffin of most startups within the first two years. Founders need enough revenue to cover production expenses and other costs. Rising variable expense with no increase in production means the company is on the road to cash flow problems. The tool founders can use to make budget changes before the next production period is meticulously monitoring each metric.
3. Establish Revenue Goals
Fixed expenses are a blessing in disguise. Unless you make substantial changes, they remain consistent. They are a dependable deduction to your monthly budget, and they give you a permanent number that needs to be paid for through revenue.
Goal out revenue and use cash-flow projections to ascertain doable revenue goals that cover all expenses. It can be hard to forecast variable expenses accurately, but fixed expenses act as the baseline for cash goals.
Tracking Fixed And Variable Expenses With Zeni
Well-maintained books mean reliable, accurate records of all payments towards fixed and variable expenses. It’s less complicated to keep up with expenses when production volume is low. Once your business grows, or there’s a sudden jump in demand, things can get messy quickly. You need proper records for yourself, and you’ll also need to provide the IRS with accurate numbers come tax time.
We know the importance of having a good bookkeeper that keeps pace with a growing company. To combat the trial and error of finding a decent bookkeeper, we created Zeni. We pair our clients with a team of experienced finance experts that work with our AI-powered bookkeeping software to ensure you always have a clear picture of your expenses.
View your top expenses broken down by percentage on the homepage of a personalized interactive dashboard. Or check your easy-to-read income statement for fixed and variable expenses updated in real-time. There’s no more waiting for the month's end to see where your production costs land when we’re doing your books.