fbpx

What Are Fixed Expenses: Definition, Examples

Expense management might be the least exciting part of owning and running your small business, but exciting or not, it’s a key part of accounting and is crucial to your business’s financial health and profitability. After all, seeing the money come in is much more satisfying than watching it go out in the form of expenses.

Part of expense management is knowing how the different kinds of expenses in your business impact your cash flow and profitability. Understanding your business’s expenses isn’t simply monitoring the amount of money you pay out each month, but also noticing the type of expenses. 

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, and those are your fixed expenses. We’ll take a closer look at fixed expenses here.

What Is A Fixed Expense?

Fixed expenses are a type of overhead expense, which is essentially 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.

While fixed expenses typically don’t change, if a fixed expense does change, it typically happens on an annual basis and during a renewal period. More commonly, they remain the same for several years.

Some fixed expense examples include:

  • Rent
  • Insurance
  • Salaries
  • 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.

Fixed Expenses Examples

In addition to the fixed expense examples in the section above, let’s go for a hypothetical situation. 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 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.

Fixed Expense vs. Variable Expense

Variable expenses are those that are ever-changing, meaning a business could experience variable expenses if they are always buying from new vendors on a one-time basis, regularly has different payroll obligations, and anything else that could cause monthly payments to be different from one month to the next. Some variable expenses are unpredictable and don’t correlate to your revenue or other business activity at all, like legal expenses, as they don’t coincide with the natural ebb and flow of your business. Because of that, managing variable expenses can be just as tricky as fixed expenses.

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 you 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.

Variable expenses can be reduced when your business experiences a loss of revenue or a decrease in activity, but sometimes decreased sales can result in higher variable expenses, especially when you have to pay higher prices to maintain your product. 

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.

How to Budget for Fixed Expenses

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. Creating and maintaining a cash reserve is just as important as investing in business growth. Using this strategy to build a reserve of three to 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 and are also some of the hardest expenses to adjust. Planning ahead to ensure you always have a reserve of cash will help you during months when sales are down or cash is tight.

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.

The best approach is 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.

The post What Are Fixed Expenses: Definition, Examples appeared first on Fundera Ledger.

This post was originally published on this site

GET UP TO $500K IN BUSINESS FUNDING

Pin It on Pinterest

Share This
Xiphos Web Marketing

FREE
VIEW