The key to having a successful financial situation is to make a reliable and realistic budget and stick to it. Creating a budget requires the critical element of listing all the expenses and categorizing them as fixed or variable. Managing a company’s budget is not easy with total expenses and production changing every month and different expenses affecting the profit level differently. Let us have a look at how to distinguish between these expenses and how correctly doing so affects the budget.
Fixed Expenses
As the name suggests, fixed expenses are “fixed”, that is, the same amount needs to be paid each month. For businesses, these expenses do not change if the number of units produced varies. Regardless of the level of production, fixed expenses need to be paid every month. These are items like rent, lease payments, utility bills, insurance expenses or capital equipment like furniture or machines. Even if no units are produced, these expenses need to be paid.
Variable Expenses
Variable expenses vary as per the number of units produced or the volume of the business. For businesses, these expenses like cost of raw materials, supplies or hourly labour expenses increase as more units are produced. Since these amounts change every month, it is difficult to plan ahead unless the production level is forecasted perfectly.
Some variable expenses are discretionary in nature, like gifts given out per unit to customers or staff parties and bonuses. These extra expenditures generally do not impact the business even if stopped.
How do these expenses affect your budget?
The key to making your financial position more profitable is through minimizing expenses by cutting down unnecessary expenditures and managing the fixed costs better. For this, it is important to classify the expenses correctly and focus on reducing the right category of expense to maximize profits.
For enterprises with large production, it may be better to have more fixed costs as the large number of units produced help in reducing the average fixed costs. And thus, the average total costs are minimized through higher fixed costs.
But for businesses with a smaller turnover, it may be better to have more variable costs, as that would help in minimizing the average total costs. With per unit costs at a minimum point, the business can price their products accordingly and concentrate on increasing their market share and profits.
While preparing the budget, it is important to look at the bigger picture and then decide whether to have more fixed costs or more variable costs that can help in maximizing the profits and minimizing the risks. A firm can look at the average variable expenses for a year and then decide whether it may be profitable to have a fixed cost instead. For example, labour with hourly pay mode can be provided with an annual pay option if the work is regularly distributed throughout the year. This may in fact also improve employee morale and bring more stability to the company’s operations. Having more fixed costs help in bringing more operating leverage and revenue growth translates into higher operating income.
Conclusion
Planning a budget for the financial year requires careful evaluation by listing all the possible costs and categorizing them as fixed or variable. Companies need to look at the volume of business to make a correct decision on whether to have more fixed costs or more variable costs. This has a direct impact on the risk level of the company as higher fixed costs mean a higher risk, but also mean higher operating profits with increase in revenues. Minimizing the average total costs require a higher component of fixed costs as with higher volume the average fixed costs go down. So, with proper planning and careful budget creation and implementation, one can achieve financial success smoothly.
