Is Entertainment a Fixed or Variable Expense?

When managing a business, understanding how expenses are classified is a fundamental aspect of financial health and strategic planning. Businesses incur various costs that impact profitability and cash flow, and these costs behave differently depending on business activity. Correctly categorizing these expenditures, such as entertainment costs, helps in accurate financial reporting, budgeting, and making informed operational decisions.

Understanding Fixed and Variable Expenses

Fixed expenses are costs that remain constant regardless of production or sales volume. These expenses are predictable and incurred regularly, providing a stable base for budgeting. Common examples include monthly office rent, insurance premiums, and the salaries of administrative staff.

In contrast, variable expenses change in direct proportion to the volume of business activity. As production or sales increase, these expenses typically rise, and they fall when activity decreases. Examples include the cost of raw materials, sales commissions, and hourly labor directly tied to production output. Fixed costs are time-related and stable, while variable costs are volume-related and fluctuate.

Categorizing Entertainment Costs

Classifying entertainment costs depends on the specific nature and purpose of the expense. Most traditional entertainment expenses are considered variable because they are incurred for business development efforts or client engagement. For instance, costs for client dinners tied to securing a new sales contract or event tickets for prospective customers typically increase with more sales efforts. These expenses are directly linked to activities aimed at generating revenue, making them variable.

While most entertainment costs are variable, there are rare scenarios where some entertainment-related expenses might behave like fixed costs. An example could be a consistent, non-discretionary annual budget allocated for employee morale events, such as a company-wide holiday party, that occurs regardless of sales volume. However, even in such cases, the primary purpose is usually to maintain a productive workforce, which is an ongoing operational cost rather than a direct sales-driven expense. Since the Tax Cuts and Jobs Act (TCJA) of 2017, most entertainment expenses are generally not deductible for tax purposes.

Determining the Classification

To classify an entertainment expense, consider several factors. First, evaluate the expense’s relationship to activity levels: does the cost directly increase or decrease with sales, production, or client acquisition efforts? If the expense is incurred more frequently or in larger amounts as business activity grows, it strongly indicates a variable cost. For example, hosting more client events to close more deals points to a variable nature.

Second, assess the predictability and regularity of the expense. Is it a recurring, predictable cost that is incurred regardless of immediate business performance, or is it sporadic and event-driven? Costs that arise only when specific business development opportunities occur are typically variable. Lastly, consider the purpose of the expense: is it a direct cost of generating revenue, or an overhead cost of maintaining general operations? Most entertainment expenses, especially those aimed at clients or business development, are designed to directly support revenue generation.

Despite changes in tax deductibility, their accounting classification for internal financial management remains important. For instance, while tickets to sporting events for clients are generally not tax-deductible, they are still a business cost that varies with client engagement efforts. Businesses must track these non-deductible costs for accurate financial reporting, often using specific expense categories like “Client Entertainment Expense.” Business meals, however, may still be 50% deductible if they meet certain criteria, such as having a clear business purpose and not being lavish.