What Is the Difference Between Fixed and Variable Expenses?
Uncover the core ways expenses function. Knowing their distinct behaviors is vital for clear financial understanding and decision-making.
Businesses and individuals incur costs to operate. These monetary outflows, known as expenses, are deductions from revenue to determine net profit or taxable income. The Internal Revenue Service (IRS) defines business expenses as “ordinary and necessary” costs paid or incurred during the taxable year for carrying on any trade or business. Understanding how different expenses behave is fundamental for sound financial management.
Understanding Fixed Expenses
Fixed expenses are costs that remain constant in total, regardless of the level of activity, production, or sales volume. These expenses are predictable and do not fluctuate with output fluctuations. For instance, a business’s monthly rent payment remains the same whether it produces 100 units or 1,000 units in a given month.
Common examples of fixed expenses include lease or mortgage payments for office or factory space. Insurance premiums, like general liability or property insurance, are also fixed, as they are paid regularly irrespective of business activity. Depreciation on equipment or buildings represents a fixed expense. Salaries for administrative staff not directly involved in production are considered fixed since their pay does not change based on output.
Understanding Variable Expenses
Variable expenses are costs that change in total directly in proportion to the level of activity, production, or sales volume. As business activity increases, the total variable expenses rise, and as activity decreases, total variable expenses fall. This direct relationship means that the cost per unit for a variable expense remains constant.
Examples of variable expenses include the cost of raw materials. Direct labor wages for production-line workers are also variable. Sales commissions increase directly with higher sales. Shipping costs and packaging expenses are variable. Certain utilities, like electricity for manufacturing, can also behave as variable costs.
Why Differentiating Expenses is Important
Distinguishing between fixed and variable expenses is important for understanding how costs behave as activity levels change. This understanding allows individuals and businesses to anticipate how their total expenses will be affected by fluctuations in sales or production. For instance, fixed costs will continue even if there is no activity, creating a baseline financial commitment.
The differing behavior of these expenses influences a business’s operating leverage, which describes how changes in sales volume affect operating income. A higher proportion of fixed costs means greater operating leverage. Variable costs directly determine the cost of each unit produced or sold, impacting per-unit profitability. Recognizing these distinctions provides clarity on how financial commitments respond to operational changes.