Fixed vs Variable Costs: Understanding the Basics for Better Budgeting
Ezra Cabrera | October 14, 2024
As a small business owner, managing your finances starts with a clear understanding of your expenses. Every dollar matters, and knowing the difference between fixed and variable costs can significantly impact your ability to budget effectively.
Fixed expenses, like rent or salaries, stay the same each month, providing predictability. On the other hand, variable expenses, such as materials and utilities, fluctuate with your business activities. Knowing the difference between these two types of expenses that affect your cash flow can help you plan better, optimize profits, and make smarter financial decisions.
Let’s get into the essentials of fixed and variable expenses to boost your budgeting strategy.
What Is the Difference Between Fixed vs Variable Expenses?
Fixed expenses are costs that stay the same every month, no matter how much your business earns or how active it is. Examples include rent, loan payments, and insurance. These costs are predictable, making them easier to plan for.
On the other hand, variable costs change depending on how much business you do. For example, if you sell more products, your materials, shipping, or utilities expenses might increase. These costs can fluctuate, making them harder to predict but giving you more control over them.
What Are Fixed Expenses?
Fixed expenses are regular costs that remain the same each month, regardless of how much revenue your business generates. These expenses are predictable, which makes them easier to budget for because you know exactly what to expect. Fixed expenses include rent, lease payments for equipment, employee salaries (for full-time staff), insurance premiums, and loan repayments.
Since a fixed cost remains the same, they provide stability in your financial planning. Whether your sales increase or decrease, your fixed costs remain constant, ensuring you can plan around them without worrying about sudden changes. However, because they are recurring and unchanging, it's important to account for them carefully in your overall budget to avoid cash flow issues.
What Are Examples of Fixed Costs?
Here are common fixed expenses for small businesses:
Rent or mortgage payments for business premises
Salaries for full-time employees
Insurance premiums (health, liability, property)
Loan repayments (business loans, equipment loans)
Lease payments for equipment or vehicles
Property taxes
Software subscription fees
Internet and phone services
Utility bills (if billed at a fixed rate)
Depreciation of equipment
What Are Variable Expenses?
Variable expenses are costs that change based on the level of business activity. Unlike fixed expenses, these costs fluctuate depending on production levels, sales volume, or service demand. Common examples of variable expenses include raw materials, packaging, shipping costs, utilities (like electricity that rises with increased production), and hourly wages for temporary or contract workers.
Variable costs are more difficult to predict because these expenses can increase or decrease depending on how busy your business is. However, they offer flexibility in your budget, allowing you to adjust spending based on current needs. For example, during periods of high demand, your variable expenses will likely rise, but during slower times, they may decrease. Understanding and monitoring these costs is crucial for managing your cash flow and keeping your budget adaptable to changes in business conditions.
What Are Examples of Variable Costs?
Here are common variable expenses for small businesses:
Raw materials and supplies
Packaging costs
Shipping and delivery fees
Utilities (electricity, water, etc., when usage varies)
Hourly wages for temporary or contract workers
Sales commissions
Credit card transaction fees
Advertising and marketing costs (based on campaign activity)
Inventory costs (as demand changes)
Maintenance and repair costs (if tied to usage)
How To Budget for Fixed and Variable Expenses for Small Businesses
Building a budget that accounts for both fixed and variable expenses is crucial for maintaining control over your small business finances. Here's a detailed guide to help you understand how to manage these two types of costs:
Start by listing out your fixed expenses, such as rent, salaries, insurance premiums, and loan repayments. Since these costs remain consistent, budgeting for them is relatively straightforward.
It's important to make sure that your business can cover these costs even during slower months, as they are not flexible.
This step provides a reliable baseline for your overall budget and ensures you're prepared for essential payments regardless of revenue fluctuations.
Tips on How To Save on Variable Expenses
Reducing a variable cost can improve cash flow and increase profitability. Here’s a quick look at how you can manage and cut variable costs:
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Negotiate with Suppliers
Suppliers often have flexibility in pricing, especially if you’ve been a long-term customer or are making larger purchases. Regularly review your contracts, and don't hesitate to ask for bulk discounts, loyalty incentives, or better payment terms. Even a small discount can add up when dealing with high-volume purchases, allowing you to lower your overall costs.
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Streamline Operations
Inefficiencies in your operations can lead to unnecessary business expenses. Analyzing your processes lets you find areas where you can cut down on waste—whether that’s reducing the amount of materials used in production or minimizing labor hours for certain tasks. For example, automating repetitive tasks or reorganizing workflows can save time and resources, leading to lower operational costs.
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Use Energy Efficient Equipment
You can minimize variable utility costs, such as electricity and water, by investing in energy-efficient equipment or implementing energy-saving practices. Upgrading to modern, energy-efficient machinery or simply installing energy-saving light bulbs can significantly reduce your monthly utility bills. Over time, the initial investment in energy-efficient tools can pay for itself through lower energy expenses.
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Outsource Non-Essential Tasks
Rather than hiring full-time staff for tasks that don’t require constant attention, consider outsourcing. This can include bookkeeping, graphic design, or IT support roles. Outsourcing as needed can help you reduce wage expenses, employee benefits, and other labor-related costs. Freelancers or specialized service providers can offer flexibility and cost savings, especially when the need for such roles fluctuates.
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Monitor Inventory Levels
Maintaining too much inventory can lead to higher storage costs, spoilage, or outdated products. Conversely, running out of stock can result in missed sales opportunities. Implementing a robust inventory management system strikes the right balance—ordering just enough to meet demand without overstocking. This practice will help you save on storage, reduce waste, and better manage cash flow.
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Shop Around for Better Rates
Regularly reviewing your service providers and vendors can uncover opportunities for cost savings. For example, compare rates from shipping companies, office supply vendors, or insurance providers to ensure you get the best deal. Even switching to a more affordable phone or internet plan can help lower your expenses. Don’t hesitate to change providers if you can secure a better deal elsewhere.
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Plan for Seasonal Variations
If your business experiences seasonal highs and lows, it’s essential to adjust your variable expenses accordingly. For example, you might reduce staff hours during slower seasons, scale back on marketing efforts, or delay large inventory orders. Planning ahead for these fluctuations can prevent overspending during low-revenue periods and ensure you’re not carrying unnecessary costs when business slows down.
Tips on How To Save on Fixed Expenses
While fixed expenses remain constant each month, there are still ways to reduce them and improve your business's financial health. Here's how to cut down on these costs:
If your lease agreement is nearing renewal or you’ve been a reliable tenant for several years, approach your landlord about renegotiating the rent. Many landlords prefer to keep good tenants rather than deal with the hassle of finding new ones, so you may be able to secure a rent reduction or other favorable terms, like spreading out payments or getting a rent freeze. Offering to sign a longer lease in exchange for lower rent can also provide savings and long-term budget predictability.
The Bottom Line
Knowing the difference between variable and fixed costs is essential for managing your business budget effectively. Fixed expenses stay the same each month, giving you a predictable foundation, while variable expenses change with your business activity.
Understanding how these two types of costs impact your cash flow can create a more flexible and realistic budget. This helps you avoid unexpected financial surprises and make smarter spending decisions. In the long run, mastering these basics will give you greater control over your finances and set your business up for long-term success.
Common Questions. Straight Answers.
Variable expenses should be planned after fixed expenses because fixed costs are non-negotiable and must be covered first, while variable costs can be adjusted based on available funds.
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