Understanding the Differences Between Fixed and Variable Expenses
If you are looking to improve your financial performance, the first step is gaining an understanding what your practice financials are telling you. Your profit and loss statement is a report card that tells you how you did over a certain period of time. However, the P & L will have little influence over future decisions if you are unable to determine what levers to pull to turn an ‘F’ into an ‘A’.
Understanding the difference between a fixed expense and a variable expense is the first key to using your P & L as a tool for improving future performance. A fixed expense is one that does not vary much over time. Most larger practice expenses fit in this category – staff salaries and benefits, office rents, and most administrative overhead. Variable expenses are exactly what they sound like – expenses that vary with production. A lot of your clinical expenses fit into this category.
Why does this matter? A firm understanding of your fixed and variable expenses will allow you to predict what your net income will be at various levels of production. This also means that if you have a specific net income target in mind, you can compute the production (revenue) target that is required to make that happen. Once you have set your desired revenue target, then you can work with your team on an operational plan to achieve that target.
What are the process steps?
- Pull a list of your expenses from your accounting software.
- Determine which expenses are fixed and which are variable. Some expenses will have elements of variability (your power bill, for example, will be higher in the summer months) while still being generally fixed. The only truly variable expenses are those that fluctuate with your production.
- Based on the last year, estimate the annual amount of each expense. Don’t spend too much time trying to get this perfect. Ballpark estimates are fine.
- Sum all of your fixed expenses and divide by 12 to get a monthly fixed expense estimate.
- Sum all of your variable expenses and divide that sum by your prior year collections. This will be your variable expense percentage.
Your result will be expressed as follows: Fixed expenses $50,000 per month, variable expenses 15% of collections. What is next?
Let’s assume in this example that you want to know what volume of practice collections will be necessary for net income of $400,000. We can calculate that collections volume with the following equation:
x * (1 – .15) – ($50,000 *12) = $400,000
x * .85 – $600,000 = $400,000
x * .85 = $1,000,000
x = $1,176,470
Oh no, not algebra! Don’t worry, we can do this in a spreadsheet that illustrates the full slate of revenue and expenses by month. And because you more than likely have some seasonality in your productivity, you will want monthly revenue targets that reflect this seasonality.
The main purpose of this exercise is to turn your historical financial statements into a forward-looking scorecard that drives operational decisions with an end goal in mind. The very first step is understanding how fixed and variable expenses can influence that process.