What is the difference between fixed and variable costs in business expenses

What is the difference between fixed and variable costs in business expenses
Photo: FreedomTumZ, Bigstock

Ask a random person on the street about how to be rich; they’d answer by making more money. Ask a wise person the same question; they’d answer by spending less money. Big revenues don’t really matter much when expenses and taxes are just as big, or even bigger.

Understanding your expenses is just as paramount to knowing how you’re going to make money. I’ve seen colleagues going into business without a single financial staff in tow, thinking that with the help of accounting software, they could learn small business accounting on the fly or in the case of emergencies, get an outside help.

That kind of go-getter attitude is admirable but is somewhat dangerous as while there are expenses that could be easily monitored, some aren’t as obvious and you can’t even control.

The main expenses in running a business could generally be divided into two, fixed costs and variable costs.

Fixed cost. Money you know you’re going to lose eventually.

Fixed cost is just what it says on the title, cost that would stay the same regardless of how much business you’re doing. Now, just because it says fixed, that doesn’t mean that it’s going to perpetually stay the same. It’s more appropriate to say that fixed costs are those whose changes you have a measure of control over or one whose costs rise gradually over time without any change in production.

Examples of fixed costs include rent for office space and web hosting services or software licensing, no matter how much business you’re doing or clients you’re servicing, the cost is going to stay the same, assuming there is no gentrification involved.

Other examples of fixed costs include salaries for employees, insurance costs and certain taxes.

Reducing your fixed cost is possible but almost always requires a relatively major decision or two, like moving to a cheaper office space, whether to a smaller one or a less expensive neighborhood, or dismissing one of your employees. As such, while reducing your fixed cost could substantially boost your cash flow, it’s not exactly the first thing you think of cutting.

They are by nature easier to manage and keep track of so this is one thing that you should theoretically be able to handle on your own, except for maybe taxes.

Variable cost. Money you don’t know you’re going to lose but would be glad to.

Why exactly is that? Because variable cost is literally the price you pay for your success. Variable cost is defined as the kind of cost that rises and declines with the corresponding movement in your sales volume.

Examples of variable costs include fresh ingredients for restaurants, materials for manufacturing companies, utility bills and shipping costs. Now, while variable cost is usually related to the amount of sales you’re accruing, it can sometimes be affected by external factors. In the food industry for example, it is common knowledge that one-third of global food is lost or wasted before they arrive at consumers’ hands.

Usually though this kind of operational inefficiency is accounted for in the budget but not always, so it pays to be aware of these types of issues.

As changes in variable cost are nowhere near as disruptive as fixed cost, this is usually the first thing business owners look at when they’re trying to trim down on expenses. While the changes associated with this cost is usually small, it can be substantial if the scale of your business is big enough.

For example, in The Founder film I’ve mentioned at the beginning, McDonald’s uses actual ice cream as an ingredient for their milkshake. The ice cream itself isn’t that expensive but the cost of having to keep those ice cream refrigerated definitely is and since every franchise they have is required to adhere to the same standard of quality, they add to quite an excessive amount of money.

The shortcut presented in the film is to switch to powdered milkshakes, dramatically reducing costs while roughly keeping the same flavor. It wasn’t factual but it does illustrate how much money you could save with variable cost depending on how many corners you are willing to cut.

What about mixed costs?

There is actually a third category of cost that is a mix between the two called mixed costs. Like the name implies, it is a combination of fixed cost and variable cost, of which the foremost example is the money going to your employee.

Most employees work under a fixed salary but some, especially in sales, work under the promise of commission on top of a fixed salary. As you know, commission is given out based on percentages, the more business a particular employee brings, the more commission they get, which means that it falls under variable cost while their fixed salary is considered fixed cost. It depends on whether you look at their wage as separate entities or not.

Businesses are to scale, it means that as your business grows, the money and complexity involved could very well grow exponentially. Small business accounting is called that for a reason, because it only covers small businesses.

While the basic still applies to large corporations, the sheer complexity of managing a multi-billion dollar business means that the waters are even murkier but one fact remains absolute, profit over gross revenue.

This current startup economy gives considerable leeway to businesses, allowing companies to burn large amount of cash even with the promise of profitability nowhere in sight. Take heart the case of Uber for example.

Despite growing massively in the last 8 years and now operating in over 60 countries and 400 cities, Uber continually post quarterly losses of hundreds of millions of dollars. That is not the right way to do business.