Some of your business expenses, such as materials and payroll, vary relative to the amount of business you transact. A restaurant buys more ingredients and pays staff for more hours when it's busy as opposed to when it's slow. A factory uses additional materials and pays more operators to install them when it receives an influx of orders. But some expenses, such as rent, are unlikely to vary as your business grows – unless it grows so much that you have to move to another facility. Accountants refer to these stable, predictable costs as fixed expenses.
Why Fixed Expenses Matter
Fixed expenses provide an important part of the equation when figuring out how much it costs to produce each unit your business sells. Expenses such as materials and payroll vary with the number of units you produce, but their cost per unit stays reasonably stable. For instance, you need two pieces of bread to make each sandwich, regardless of whether you're making two sandwiches or 200. But the cost of fixed expenses decreases per unit as your business increases, regardless of the fact that the total cost of these expenses remains essentially the same. If your rent is $1,000 per month and you only produce one unit, your rent cost per unit is $1,000. But if you produce 1,000 units, your rent cost per unit decreases to $1. Understanding your company's outlay for fixed expenses helps you understand how much business you need to transact to lower the fixed price per unit to the point where your business is profitable.
Some Common Fixed Expenses
Aside from rent, your business pays for many fixed expenses. If you're depreciating equipment purchases from previous years, the amount of your depreciation deduction doesn't fluctuate relative to your sales volume. Your insurance premiums are stable, fixed costs as well. Rates may fluctuate relative to your safety record, but they're unlikely to change relative to the number of units you produce. The cost of business licenses tends to be relatively stable as well. You may pay more for a business license if your gross annual sales exceed a certain amount specified by your city or state revenue department. This cost increase is usually relatively small, and it corresponds with reaching a particular threshold rather than correlating directly with your company's sales.
Nuances of Fixed and Variable Expenses
Although the idea of fixed and variable expenses is a handy accounting concept that helps you think through these different types of expenditures, the distinction isn't always clear-cut. Production payroll is a variable cost, but accounting payroll is a fixed expense because you need to keep your books regardless of whether business is slow or booming. If you own a restaurant, you'll have more staff on the floor on busy nights but you need a skeleton staff for both the front and back of the house even if you don't have a single customer walk in the door. It may be counterproductive to try to assign each of your payroll hours as a fixed or variable expense, but it's useful to know that the correlation between payroll cost and sales volume can be somewhat murky.