Fixed Expenses vs. Variable Expenses: Key Differences

Understanding the difference between fixed and variable expenses is crucial for effective business budgeting and financial planning. Fixed expenses are costs that remain largely the same each month. Knowing what comprises your business’s fixed costs allows you to accurately forecast and budget for them.

What Are Fixed Expenses?

Fixed expenses are periodic business costs that don’t change dramatically from month to month. They are incurred regularly and can be reliably predicted and budgeted for.

Some examples of common fixed business expenses include:

• Rent
• Loan payments
• Insurance premiums
• Salaries
• Equipment leases
• Software subscriptions
• Professional services retainers

Even if fixed costs may increase/decrease over longer periods, like annually, they are essentially fixed each month. These expenses are unavoidable regular costs needed for the business’s operation.

Fixed costs stay the same irrespective of production or sales volume. For example, even if a retail store’s sales dip during slow periods, their rent remains the same. A manufacturer has to pay their factory lease even if they produce less one month.

Key Attributes of Fixed Expenses

There are three main attributes of fixed expenses in business:

1. Predictability

The amounts do not vary dramatically from month to month, so budgets can confidently rely on fixed historical amounts. Even if an increase occurs, like in insurance premiums at renewal, it is usually a small percentage change.

2. Recurring nature

These expenses recur regularly, like rent paid every month. Some may recur quarterly or annually but are still fixed when they come due.

3. Must be paid

Fixed costs are unavoidable expenses required to keep the business operating. They cannot simply be eliminated if sales decline in a particular period.

Fixed Expenses vs. Variable Expenses

While fixed costs remain fairly static, variable costs fluctuate directly with a company’s production volumes or sales. Some examples include:

• Raw materials
• Packaging
• Commission percentages
• Piece rate payments
• Inventory carrying cost

Variable costs only change when activity rises or falls. If a manufacturer builds 500 instead of 1,000 widgets, they use less raw material and pay fewer employee hours.

In contrast, fixed costs remain unchanged despite output swings. A key priority in financial management is to control the fixed expense base and optimize the ratio of fixed to variable costs.

Examples of Common Fixed Business Expenses

Below are some typical fixed costs that businesses incur:

• Rent: Office, retail store, factory or warehouse rent. Rent is usually fixed per the lease terms.
• Mortgage payments: For owned business properties like offices and factories. The amounts are fixed monthly.
• Equipment leases: Leasing production equipment, computers, company cars etc. involves fixed monthly payments.
• Insurance: Premiums for business insurance policies like liability and property insurance. Premiums are fixed for each policy term.
• Loan payments: Regular principal and interest repayment for business loans and lines of credit.
• Salaries: Regular payroll expenses for employees on salary contracts.
• Licenses & permits: Annual or multi-year business license and regulatory permit fees.
• Software subscriptions: Ongoing SaaS software fees paid monthly or annually.
• Professional retainers: Fixed monthly fees paid for services like accounting, legal counsel, IT support.
• Advertising contracts: Some media advertising commitments involve fixed periodic fees.
• Facility maintenance: Regular upkeep and maintenance of business premises and equipment.
• Security contracts: Having guards, alarm systems and security services on a fixed contract basis.

Ways Businesses Can Reduce Fixed Expenses

While fixed costs are generally unavoidable, some strategies can help minimize them:

• Renegotiate leases – Seek better terms before renewing facility or equipment leases.
• Review insurance – Shop policies to find more optimal rates/coverage.
• Negotiate contracts – Get better deals from suppliers and service providers.
• Consolidate services – Bundling needs, like telecoms, can mean lower overall costs.
• Analyze staffing – Assess if employee base and salaries are optimized.
• Automate processes – Using technology to eliminate manual processes and cut labor expenses.
• Relocate – Consider moving to a cheaper geographic area.
• Outsource – Weigh having external providers perform non-core functions.
• Go remote – Telecommuting can allow downsizing physical offices.
• Extend useful life – Maintain assets optimally to extract full value before replacement.

The Bottom Line

Accurately budgeting for known fixed commitments is vital for business planning. Underestimating fixed costs risks unexpected cash shortfalls as bills come due. Fixed expenses may not be entirely inflexible, but require proactive management focus to minimize.

Understanding the magnitude and timing of fixed outflows provides a baseline to layer in variable activity-driven costs. This full picture allows realistic budgeting and supports operational and strategic decision making. By spending time to regularly analyze their fixed cost base, management can identify opportunities for improvement.

Frequently Asked Questions

What are the main types of fixed expenses?

Typical fixed business expenses include rent, mortgage payments, leases, insurance, loan payments, salaries, licenses, software subscriptions, professional retainers, advertising contracts, maintenance, and security.

Why are fixed expenses important for business forecasting?

Accurately estimating future fixed costs allows companies to realistically forecast cash flow needs, financing requirements, profitability, breakeven points, and other key performance metrics.

How often should businesses review their fixed expenses?

Fixed costs should be reviewed at minimum annually, but ideally quarterly. This allows timely adjustments to budgeting and identifies opportunities to optimize fixed outlays well before expense commitments renew.

Can fixed costs ever be reduced significantly?

While fixed expenses cannot simply be eliminated at will, focus on major fixed categories can yield material reductions over time. For example, renegotiating leases and service contracts, streamlining staff and automation can lower fixed costs.

How do variable costs differ from fixed expenses?

Variable costs fluctuate directly with production volume or sales, while fixed costs remain unchanged despite activity changes. Managing the ratio between the two is an important focus for optimizing profitability.