An expense is a cost incurred by a business in its operations to produce revenues. Expenses in accounting can be either variable or fixed. A fixed expense doesn’t change with the level of usage or production, such as the rent paid for a building, whereas a variable expense changes with the production or the amount used, such as how your electric bill varies with the amount of electricity used.
Variable Expenses Defined
A variable expense is a cost that changes depending on your production level. Here are some of its key characteristics:
- Variable expenses fluctuate depending on external factors, such as changes to the price per unit of electricity or fuel.
- Variable expenses may increase or decrease based on your output because you’ll need to buy more raw goods and spend more on hourly labor to produce more output.
- Variable expenses are often volume-related, such as the amount of time your employees work per week.
Examples of Variable Expenses
- Utilities, such as gas and electricity
- Hourly wages and direct labor
- Sales commissions
- Merchant and bank fees
- Raw materials
- Shipping and packaging costs
Budgeting for Variable Expenses
With variable expenses, the per unit expense remains constant while the total expense increases with production.
Let’s consider the example of a company that produces sunglasses. It cost $5 in raw materials and $20 in direct labor to create one pair of sunglasses. In addition, there are fixed costs of $500, which represents the equipment that was used.
To illustrate this concept, view the table below and note how the costs change as more sunglasses are produced.
Sunglasses | Raw Material Costs | Direct Labor Costs | Total Variable Costs | Fixed Costs | Total Costs |
|---|---|---|---|---|---|
0 | 0 | 0 | 0 | $500 | $500 |
1 | $5 | $20 | $25 | $500 | $525 |
5 | $25 | $100 | $125 | $500 | $625 |
10 | $50 | $200 | $250 | $500 | $750 |
20 | $100 | $400 | $500 | $500 | $1,000 |
50 | $250 | $1,000 | $1,250 | $500 | $1,750 |
Regardless of how many sunglasses are produced, the variable cost per unit is $25. To budget for total variable costs, you’ll need a good estimate of the number of sunglasses produced. However, it’s very easy to incorporate variable costs in the sales price to make a profit since the cost is fixed per unit.
Fixed Expenses Defined
Fixed expenses are commonly referred to as “overhead.” They usually stay the same regardless of how much business you’re doing. Here are some key characteristics:
- Fixed expenses aren’t impacted by production output. For example, you’ll pay rent for your office every month, regardless of how much work you do there.
- Fixed expenses remain static over a set amount of time, such as your monthly insurance payment.
- Fixed expenses are often time-related, such as your annual license fee.
Examples of Fixed Expenses
- Rent
- Leased equipment
- Insurance
- Salaries
- Property taxes
- Depreciation
- Interest expenses
Budgeting for Fixed Expenses
With fixed expenses, the total expense remains constant while the expense per unit decreases with production.
Let’s refer to the example in the table above. If you divide the fixed cost amount of $500 by the number of sunglasses produced, it’ll determine the fixed cost per unit. The fixed cost per unit ranges from $500 per unit when one pair of sunglasses is produced to $10 per unit when 50 pairs are produced. You’ll then incur a lower cost per unit and generate a higher profit.
Sunglasses | Fixed Costs | Total Cost per Unit |
|---|---|---|
1 | $500 | $500 |
5 | $500 | $100 |
10 | $500 | $50 |
20 | $500 | $25 |
50 | $500 | $10 |
Total fixed costs are easy to budget since they remain constant regardless of production. However, the cost per unit to incorporate in your sales price depends upon accurately forecasting the number of units produced.
Variable vs Fixed Expenses & Relevant Range
Fixed expenses are only fixed within a relevant range of activity. If the level of activity exceeds the relevant range, then fixed expenses may increase. For example, the expense to rent office space is usually a fixed expense. However, what if the company doubles in size? At some point it’ll probably have to rent additional office space and therefore office rent will increase. In accounting terms, its office activity exceeded the relevant range; therefore, the fixed expense increased to a new level.
Frequently Asked Questions (FAQs)
Are cost of goods sold a variable expense?
No, the cost of goods sold (COGS) are comprised of both fixed and variable expenses:
- Variable COGS include raw materials, labor, and any other costs that vary with the number of goods produced
- Fixed COGS include storage costs, factory overhead, equipment rentals, and any other costs that don’t depend on the number of goods produced
Are period expenses the same as variable expenses?
No, period expenses are expenses that aren’t included in COGS or capitalized as fixed asset costs. They’re comprised of both fixed and variable expenses. Period costs are generally divided into two categories: administrative costs and selling costs. In contrast, variable expenses change based on how much a company produces and sells. Variable expenses will increase as production rises and decrease as it lessens:
- Variable period costs include labor, commissions, utilities, packaging, transportation costs, professional services, such as attorney or accountant, and raw materials
- Fixed period costs include insurance, lease and rental payments, advertising, office supplies, certain salaries, property tax, depreciation, and interest payments
Bottom Line
Managing expenses is one of the most important tasks as a business owner. Understanding expenses in accounting will help you determine the difference between variable and fixed expenses—and knowing the difference between variable and fixed expenses will help you budget for total expenses and determine a profitable sales price for your product.
