The expenses that occur in businesses are classified into two types – fixed expenses and variable expenses.
Fixed expenses are those expenses that do not change when there is a change in production or sales level. Expenses like rent, insurance, payment on loans, management salaries, advertising are examples of fixed expenses. They change over a period of time.
Variable expenses are those expenses that change with each unit of production and it is directly proportional to the level of production. When there is an increase in production of goods, then the variable costs will also increase and vice-versa. For example expenses like production wages, raw materials, sales commission, shipping costs etc. are examples of variable expense.
What is Fixed Expense?
Fixed expenses are those that will remain same despite any change in the sales amount, production or some other activity. They are expenses that will have to be paid by the company even though there are any changes in business activities. They remain constant for a specific level of production over a certain period of time. However, it may change if the production level increases beyond a limit.
- The monthly rent of a retail shop is a fixed expense and it is not dependent on the number of sales that takes place every month. Whether the sales are less or more, the monthly rent that has to be paid will be fixed.
- The cost incurred for setting up plants and machinery are considered as the fixed expense, as this cost will not change with the production level.
These expenses will be quite steady and will not tend to change every month. The expense will remain fixed within some radar of activities, but it will change after the certain limit. For example, the rent and salary paid to staff will remain fixed every month. However, when the sales increase there might require some additional space and staffing this increase in the rent and salary expense. But these expenses will remain fixed over a period of time. Changes will happen when there are likely to change any event.
Some fixed expense like advertising and promotional expense are assumed or incurred at the decisions of the management of the company. It is understood that all reserved fixed expense will suffer even if the sales fall zero. Even though the sales and production expense are the main factors that regulate the variable expense that are incurred by the company, these costs will also fluctuate with regards to few other factors like updates in the price of suppliers, promotional offers etc.
It is essential to recognize the various types of expenses as and when there is an increase in production or sales price. The fixed price will remain unaffected when the sales increases but the fixed cost per unit will drop.
Consider for example a potato chips manufacturing company. If it has total fixed expenses of Rs. 10000 and produced 100 packets of chips, then the full amount of Rs. 100 as the fixed expense will be applied to 100 packets of chips. If the same manufacturing company produced 200 packets of chips then the fixed cost per packet will drop to Rs. 50.
Examples of fixed expense
1) Real Estate
Almost all businesses will require the owner of the business to pay rent for the space that is used to conduct the business. Tax deductions can be incurred for rent that is used to conduct the business. This amount that the business pays as rent is the fixed expense which is not dependent on the performance of the company. However, the rent might increase over a period of time which is due to economic growth and it is based on the agreement signed.
Costs involved in utilities may be of the variable, fixed or mixed. Consider, for example, internet and telephone bills. It will usually be a monthly rate and will not change. Even if it changes it will be a slight change.
Consider electricity charges for offices or retail spaces. It is a fixed amount and if it varies every month, the variations will be minimal.
3) Payment to employees
A non-commission based pay is a fixed expense. Some sales representatives receive pay based on commission. This commission will rise and fall with respect to the sales volume. But they also receive a portion of their pay as fixed payment.
4) Debt expense
Some businesses will have debt. In such case, the interest that is paid is a fixed expense.
Importance of fixed expense
A company that has focused on a quite large amount of variable expense will predict more profit per unit in comparison to a company with a large amount of fixed expense. This implies that if a firm has more fixed expense, profit margin will be held when there is a fall in sales which is likely to add a level of risk to the companies’ stocks. Equally fixed costs will also allow a company to experience the increase in profit as and when the income increases, they are applied at a constant cost level.
Consider the company that manufactures potato chips. Let us assume that the cost the company spends on manufacturing 100 packets of chips per month is Rs. 1000.(Assume that the cost of a packet is Rs 10). Rs. 1000 includes Rs. 500 on administration, insurance and marketing expenses that are usually fixed expense. If the company changes the decision to increase the production to 200 packets per month, then its total production cost will rise to Rs. 1500 (Cost of one packet of chips will be Rs. 7.5), as it can distribute the fixed costs of Rs. 500 over more units. Even though the company total cost increases from Rs. 1000 to Rs. 1500, the individual packets of chips will become less expensive to produce and hence the profit increases.
Thus as seen in the example, fixed expenses are an important component to project profit and also to calculate break-even point for a business.
It is normally good to keep fixed expenses of a company as low as possible, particularly at the time when the business starts. This is because, during the first year of the business, the businesses income will be low as it will take some time for the business to establish and get customers. At this stage, maintaining low fixed expenses will help you to save money till the sales pick up.
Typically fixed expenses will generally differ based on the business. The businesses which depend on people other than physical assets like website design, tax preparation etc will not have many fixed costs. Companies like airlines; auto manufacturers etc. will have high fixed costs.