Understanding Fixed & Variable Expenses for Business Owners
As a business owner or financial executive, understanding fixed and variable costs of your business has likely been part of your annual budgeting process. If so, this article can help you refine and continue analyzing your fixed and variable costs to enhance forecasting while improving your bottom line. If you do not currently consider fixed and variable costs as part of your budget process, this information may encourage you to begin incorporating them into your budgeting.
While a static budget (one that does not fluctuate with volume changes) can benefit from identifying fixed and variable costs, the flexible budget (one that adjusts due to volume changes) makes full use of the benefits from identifying fixed and variable costs. The flexible budget provides a comparison of the actual results on an apples-to-apples comparison as it is adjusted to the corresponding volume level of actual results. Before we examine the benefits of this, let’s lay the groundwork for identifying fixed and variable costs.
A good first step to identifying fixed and variable costs is to use the chart of accounts associated with the income statement and begin classifying the accounts as fixed or variable. As you identify variable costs, you also will want to determine the driver that causes the fluctuations in the variable cost. Remember, not all variable costs will be driven by the same metric; for example, in a transportation company, miles driven will affect fuel costs, but certain wage costs may vary based on number of shipments. Some of these drivers may have already been identified within the company as key metrics and will greatly assist in understanding fixed and variable costs and their bottom-line effect.
As you go through the process of identifying income statement accounts as fixed or variable costs, you will encounter challenges. Accounts may include both fixed and variable costs. An overreaction to this is to revamp the chart of accounts and start moving expenses around. While this could be a worthwhile exercise, remember Winston Churchill said, “Perfection is the enemy of progress.” In addition, you may debate whether an expense is fixed or variable. For example, is rent a fixed cost, or does it fluctuate with volume? While in theory rent does not change, it could have increases based on changes in the consumer price index or have contingent rents (based on gross receipts, etc.). Select what works best for your company. Some additional examples would be holiday pay, insurance, salaries, and utilities. Try not to get bogged down with getting things perfect. One of the benefits of identifying fixed and variable costs comes through focusing on drivers of your business you control that positively affect the bottom line.
Once fixed and variable costs have been identified, establish a financial model incorporating the fixed and variable costs. Fixed costs should be straightforward, while drivers of variable costs, which have been identified above, will be key in calculating fluctuations of variable costs due to volume changes. Once the model has been established, comparisons to actual results can drive improved analysis and discussion, as variances due to volume changes will have been considered. Remaining variances can be further researched and understood so adjustments can be made, affecting both the process and the bottom line.
There are additional benefits to establishing a financial model that incorporates the fixed and variable costs, including its use in breakeven analysis. This may be necessary if the business is struggling during a down cycle such as a pandemic or considering offering a new product or service. During times of high revenue growth, the model should help in understanding whether the incremental revenue is improving the company’s overall margin or simply adding dollars to the bottom line, as not all revenue is created equal. Understanding how to meaningfully affect the bottom line comes from understanding your business’s fixed and variable costs.
If you are you ready to get started, BKD can help. We have teams dedicated to helping clients understand fixed and variable costs and their effects on the bottom line. After all, profit is not a four-letter word. Connect with a BKD Trusted Advisor™ by visiting our Outsourced Accounting Services page or submitting the Contact Us form below.