Most businesses experience both fixed expenses and variable expenses. Knowing the difference is important, especially if your organization reimburses employees for their business vehicle expenses.
The difference between fixed and variable costs
Whether you are operating a business or managing a household budget, you have encountered both fixed and variable expenses. The difference between a fixed cost and a variable cost depends on how often the cost changes.
A fixed cost is an expense that stays relatively unchanged each month, regardless of business output. A variable cost increases and decreases frequently based on production output or market prices. A "fixed and variable rate" reimbursement is a payment that covers both expense types.
Managing fixed and variable costs can be a challenge. This is because the two categories require different approaches when planning budgets or issuing reimbursements. Fixed costs must be accounted for first because they remain steady whether any goods or services are produced.
Examples of fixed costs and variable costs
Examples of fixed costs include:
mortgage and loan payments, insurance premiums, rent, salaries, cell phone bills, property taxes, vehicle license.
Examples of variable costs include:
hourly wage payments, sales commissions, taxes on income and sales, fuel, raw materials, utilities.
How fixed and variable costs affect businesses
All businesses should take both sets of costs into account when budgeting, setting prices, and pursuing growth. Any organization that pays a car allowance or reimbursement should also distinguish between fixed costs like insurance and variable costs like fuel.
Employees, such as sales representatives, will incur fixed expenses regardless of whether they have a productive month with numerous trips. Only their variable expenses will increase if they increase their productivity by driving more. Some reimbursement models, however, do not properly account for the fixed portion of expenses.
Mileage reimbursements and car allowances
When creating a mileage reimbursement or car allowance program, separate fixed from variable expenses. Otherwise, negative consequences to your bottom line may follow:
- Costs exceed the budget unexpectedly
- Insufficient reimbursements, reducing retention
- Over-reimbursements, reducing cost control
- Unresponsive to changing expense needs
So, what vehicle expenses fall under variable costs vs. fixed costs?
Examples of fixed vehicle expenses
Fixed vehicle expenses refer to the fixed costs associated with owning a car, regardless of how frequently you drive it. These costs remain relatively stable from month to month or even year to year:
- Auto insurance
- Depreciation
- Personal property taxes
- Vehicle license and registration fees
Does your company's mileage reimbursement take into account insurance and depreciation? These may constitute over 60% of annual vehicle expenses, but mileage rates may under-reimburse them.
Why is depreciation a fixed cost?
Vehicle depreciation is a business expense and should be reimbursed. A decrease in value counts as a fixed cost because it occurs steadily over time according to a schedule. This makes it a predictable expense.
The business portion of an employee's vehicle use determines the percentage of depreciation that a car allowance should reimburse. A business might exclude this expense from the car allowance calculation because it is not a direct expense. A mileage rate may under-reimburse the expense because the driver does not drive enough miles to cover fixed costs.
Variable vehicle expenses to be reimbursed
The variable costs of car ownership could be considered operational costs. Driving more or less will have a significant impact on these costs, as do fluctuations in market prices:
- Fuel
- Oil
- Maintenance
- Tires
How car allowances reimburse variable costs
Standard car allowances remain the same from month to month and even year to year. Paying an equal amount every month can offset fixed expenses, since they are predictable and stable. But gas prices and mileage amounts can fluctuate month to month.
Another problem arises from the differences between employees' expenses. Different employees drive different amounts, face different gas prices, and cover different-sized territories. But they each receive the same monthly allowance.
Because standard car allowances are taxable, an employee may only receive 60-70% of the allowance after taxes. This is why car allowances may be considered a violation of the law in states that require full reimbursement of expenses.
How cents-per-mile reimburses fixed costs
Mileage rates, such as the IRS rate, tend to under-reimburse fixed costs. Here's why:
When reimbursed per mile, a driver must drive a certain number of miles to cover all fixed costs. The driver must also drive an additional number of miles to cover their increasing variable costs.
What if the driver does not drive enough? Or, what if the driver drives more miles than necessary to recoup all work-related car expenses?
How a fixed and variable rate allowance works
A form of vehicle reimbursement exists that can accurately reimburse both sets of costs. The IRS refers to it as a fixed and variable rate allowance. This procedure utilizes a fixed amount to cover fixed costs and a mileage rate to cover variable costs.
The fixed and variable rate allowance, or FAVR, delivers tax-free payments to employees. The hallmarks of a FAVR reimbursement program include
- Standardized vehicle used to derive rates rather than paying a standardized rate
- Using localized vehicle expense data to derive rates rather than national averages (i.e., the IRS mileage rate)
- Periodic adjustments to both the fixed allowance and the variable rate to ensure accuracy
The benefits of a fixed and variable rate (FAVR) program
When an organization switches to a FAVR reimbursement model, the benefits are often felt quickly. In general, these benefits include
- Customized payments that are accurate for each employee
- Transparency in how reimbursement amounts are calculated
- Equitable payments that ensure fairness to all employees
- Full compliance with state labor codes like CA Labor Code 2802
Switching to a FAVR vehicle plan
Switching from a taxable car allowance or from a cents-per-mile rate can yield specific benefits:
- Removing taxes can yield a higher benefit for employees at a lower cost to the employer
- Switching from the IRS mileage rate is more scalable, protects low-mileage drivers, and increases cost control
A FAVR vehicle program can be challenging to administer initially due to the IRS regulations involved. However, with the right guidance and support, this can be a cost-effective move.
To learn more about how a FAVR car allowance could work for your organization, schedule a call. Or use the mBurse FAVR savings calculator
Or take a deep dive with our ultimate guide to FAVR reimbursements.
