A business manager needs to know which expenses in a P&L (profit and loss) report are variable and which are fixed in order to analyze a business’s profit behavior. In other words, which expenses change according to the level of sales activity in a given period, and which expenses don’t change.
The title of each expense account often gives a pretty good clue. For example, the cost of goods sold expense is variable because it depends on the number of units of product sold, and sales commissions are variable expenses. On the other hand, real estate property taxes and fire and liability insurance premiums are fixed for a period of time.
Managers should always have a good feel for how their operating expenses behave relative to sales activity. But to be honest, separating variable and fixed operating expenses is not quite as simple as it may appear at first glance. One problem is that some expenses, which are recorded on an object of expenditure basis, have both a fixed cost component and a variable cost component.
Variable expenses
Virtually every business has variable expenses, which move up and down in tight proportion with changes in sales volume or sales revenue. Here are examples of common variable expenses:
The cost of goods sold expense, which is the cost of products sold to customers
Commissions paid to salespeople based on their sales
Franchise fees based on total sales for the period, which are paid to the franchisor
Transportation costs of delivering products to customers via FedEx, UPS, and freight haulers (railroads and trucking companies)
Fees that a retailer pays when a customer uses a credit or debit card
Cost of goods sold is usually the largest variable expense of a business that sells products, as you would suspect. Other variable expenses are referred to as operating expenses, which are the costs of making sales and running the business.
The sizes of variable operating expenses, relative to sales revenue, vary from industry to industry. Delivery costs of Wal-Mart and Costco, for instance, are minimal because their customers take the products they buy with them. Other businesses deliver products to their customers’ doorsteps, so that expense is obviously much higher (and dependent on which delivery service the company uses — FedEx or UPS versus the U.S. Postal Service, for example).
Fixed expenses
Fixed operating expenses include many different costs that a business is obligated to pay and cannot decrease over the short run without major surgery on the human resources and physical facilities of the business.
As an example of fixed expenses, consider the typical self-service car wash business — the kind where you drive in, put some coins in a box, and use the water spray to clean your car. Almost all the operating costs of this business are fixed; rent on the land, depreciation of the structure and the equipment, and the annual insurance premium don’t depend on the number of cars passing through the car wash. The main variable expenses are water and soap, and perhaps the cost of electricity.
Fixed expenses are the costs of doing business that, for all practical purposes, are stuck at a certain amount over the short term. Fixed expenses do not react to changes in the sales level. Here are some more examples of fixed operating expenses:
Gas and electricity costs to heat, cool, and light the premises
Employees’ salaries and benefits
Real estate property taxes
Annual audit fee (if the business has its financial statements audited)
General liability and officers’ and directors’ insurance premiums
If you want to decrease fixed expenses significantly, you need to downsize the business (lay off workers, sell off property, and so on). When looking at the various ways for improving profit, significantly cutting down on fixed expenses is generally the last-resort option. A business should be careful not to overreact to a temporary downturn in sales by making drastic reductions in its fixed costs, which it may regret later if sales pick up again.