How Expenses Change
As a company's sales or revenues increase, some of the company's expenses will increase and some expenses will not change. For example, if a company sells a few additional products on which it pays a sales commission, the company's cost of goods sold will increase as will its commissions expense. On the other hand the salaried officers of the company and the company rent will not increase even a penny with the sale of a few more products. To help improve the profits at a company, it is valuable to know how the expenses behave—will they increase when sales increase or will they stay at the present amount. The goal is to increase sales or revenues by an amount greater than the increase in expenses. Another approach is to decrease expenses by an amount greater than a related decrease in revenues.
Expenses can be classified according to how they react to a change in revenues. Often we see three classifications of expenses:
To help explain these three types of expense behavior, we will use the example of Verve Company, a women's retail clothing store.
1. Variable expenses change in total as volume changes.
A sales commission is considered to be a variable expense. For example, let's say that instead of a salary, Verve pays its sales staff commissions equal to 10% of sales. When sales are $50,000 Verve has $5,000 of commissions expense; when sales are $70,000 Verve has $7,000 of commission expense.
With a variable expense the amount per unit (or the percent) stays constant—in this case it's 10%—but the total expense will vary with the sales volume.
You can see this with the cost of goods sold. Let's say Verve pays $7 for a particular shirt and then sells the same shirt for $10. When sales are $100, the cost of goods sold is $70; when sales are $10,000, the cost of goods sold is $7,000. Other variable expenses could include delivery expenses, wages in the shipping department, and shipping supplies used such as boxes, shrink wrap, etc.
2. Fixed expenses do not change in total as volume changes.
If Verve rents retail space for $2,500 per month, the rent remains at $2,500 whether the sales are at an all-time high or an all-time low. If Verve owns the space, the real estate taxes remain the same whether sales are high or low. Other examples of fixed expenses include such things as salaries, insurance, telephone book advertising, and most depreciation.
If sales were to increase by a huge percentage, some fixed expenses might change. For example, if sales doubled it is likely to cause an increase in rent expense.
3. A mixed expense is a combination of a variable and a fixed expense.
Let's say Verve employs a sales person who is paid a base salary of $2,000 per month plus a 2% commission on all sales. The base salary is a fixed expense; the 2% commission is a variable expense. Taken together, the salesperson's compensation is considered a mixed expense.
Some mixed expenses do not correlate with sales. Let's take the example of vehicle expenses. If a salesperson uses her car to make sales presentations to customers, expenses such as insurance, licenses, parking, and some depreciation are all fixed expenses—they stay the same within a reasonable range of miles driven, or regardless of the amount of sales. Some vehicle expenses, such as gasoline, oil changes, tires, and other maintenance will vary with the number of miles driven. But, will these expenses vary with sales? Maybe or maybe not.
To help determine (1) how much of a mixed expense is fixed and (2) the rate at which the variable portion of a mixed expense will change as some activity changes, accountants use a statistical tool called regression analysis. Consult a statistics textbook to learn more about this valuable tool.