Analyzing Expenses

When you examine your company’s income statement do you find yourself wondering why some expenses seem to have little to do with sales? There are three basic breakdowns of expenses that will help you when analyzing expenses.

Fixed Expenses

Fixed expenses are those that are essentially unchanging from month to month. I say essentially only because there could be extenuating circumstances that cause a change, but in general the amount will not change from month to month.

An example of a fixed expense is rent. Imagine your company is a distributor that rents space at $10,000 per month. That amount should not change from month to month, so if you see something other than that in a month then either something is recorded incorrectly, not recorded, or there is some kind of unusual event that caused the variance.

Since this amount remains the same from month to month, your rent expense as a percentage of sales varies according to the sales amount.

Variable Expenses

Variable expenses are those that vary in relation to some other item. For example, if as a distributor you sell two items, Item A that cost you $10 and you sell for $20 and Item B that cost you $10 but you sell it for $15, then the cost of sales will be driven by the quantity of each you sell.

For example if in a month you sold 100 of Item A and none of Item B then your sales would be $2,000 (calculated as $20 x 100) and your cost of sales $1,000 (calculated as $10 x 100). So, your gross margin would be $1,000 (calculated as $2,000 – $1,000) or 50% of sales. However, if you sold 50 of Item A and 50 of Item B then your sales would be $1,750 (calculated as $20 x 50 for Item A plus $15 x 50 for Item B). Your cost of sales would be $1,000 (calculated as $10 x 50 for Item A plus $10 x 50 for Item B). Now your gross margin would be $750 ($1,750 in sales less $1,000 in cost of sales). In this case you gross margin would be 42.9% instead of 50% of sales as in the first case.

As you can see your cost of sales varies in direct relation to the quantity of each item sold. Likewise, the gross margin and gross margin percentage also vary for the same reason.

When you are reviewing your income statement and analyzing expenses this can require a little in depth study to understand.

Semi-Variable Expenses

Semi-variable expenses are those that have a component that is fixed and a component that is variable. A classic example would be a retailer that rents space in a mall and pays rent that has a fixed monthly amount and an amount that is a percentage of sales.

For example, imagine a retailer pays a flat $2,000 per month plus 2% of sales. If sales for the month are $10,000 then the rent would be $2,000 plus $10,000 x 2% or $2,200, which is 22% of sales. On the other hand, if sales are $20,000 then the rent is $2,000 plus $20,000 x 2% or $2,400, which is 12% of sales. As you can see, trying to evaluate rent expense only as a percentage of sales is somewhat meaningless.

Much like variable expenses, when trying to evaluate your income statement you may need to do some more in-depth study to understand semi-variable expenses.

The Point of All This

Basically the point of all the above is to dissuade you from getting hooked on the idea that every expense should be examined strictly as a percentage of sales. When analyzing expenses it is important to understand these three basic typed of expenses and how they are determined. More importantly, if you want to understand your results better it is critical to do some more evaluation of your expenses.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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