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. A fixed expense stays relatively unchanged from month to month, regardless of business output. A variable expense tends to change frequently based on business output or market prices.
Examples of fixed costs: mortgages and other loan payments, insurance premiums, rent, salaries, cell phone bills, taxes on personal property and real estate.
Examples of variable costs: hourly wage payments, sales commissions, taxes on income and sales, fuel, raw materials, utilities.
It is important that all businesses take both sets of costs into account when budgeting, determining economies of scale, setting prices, and pursuing growth opportunities. It is also vital that any organization that reimburses employees for the use of a personal vehicle distinguish between fixed and variable costs. (Looking to calculate a fair, affordable car allowance or mileage rate? Here's how to set the proper amount.)
Fixed vs. variable vehicle expenses
When it comes to company vehicle programs, such as mileage rates, car allowances, or company cars, it is vital to design the program with both sets of expenses in mind. Otherwise, a number of negative consequences can ensue:
- Costs exceed the amount budgeted for the vehicle program
- Employees get shorted by insufficient reimbursements
- Inequities from both over-reimbursement and under-reimbursement
- Inability to stay responsive to changing expense needs (e.g. COVID-19 forcing some employees to drive less or not at all)
So what vehicle expenses fall under each category?
Fixed vehicle expenses to be reimbursed
The fixed vehicle expenses could also be considered ownership costs – the costs that come with owning a vehicle, whether you drive it a lot or a little. These costs remain relatively stable from month to month or even year to year:
- Auto insurance
- Personal property taxes
- Vehicle license and registration fees
Variable vehicle expenses to be reimbursed
The variable expenses for a vehicle could be considered operation costs. Driving more or less will have a significant impact on these costs, as do fluctuations in market prices:
Why car allowances do not reimburse fixed and variable costs effectively
Standard car allowances remain the same from month to month and even year to year. Our annual surveys have typically shown that the majority of employers only update their car allowance amount every 7 to 10 years.
Paying an equal amount every month could work for offsetting fixed expenses, since they are predictable and stable. Paying an equal amount every month cannot appropriately address variable expenses, especially in times when gas prices fluctuate dramatically or workers' business mileage fluctuates widely.
But even in times of more predictable variable expenses, standard car allowances create inequities across the company. This is because different employees drive different amounts, face different localized gas prices and maintenance costs, and cover different sized territories. But they each receive the same monthly allowance.
It is also important to note that standard car allowances are taxable, which can mean that an employee only receives 60-70% of the allowance after taxes. This is why car allowances often leave workers undercompensated for their vehicle use and may violate labor codes in states like California that require full reimbursement of business expenses to employees.
Why mileage rates (e.g. the IRS rate) do not reimburse fixed and variable costs effectively
Since variable costs increase with increased travel, it makes sense to reimburse employees per mile, right? The problem is, mileage rates tend to under-reimburse fixed costs. Here's why:
If a driver is reimbursed per mile, then that driver needs to drive a certain number of miles in order to cover all fixed costs before the mileage reimbursement starts to cover the driving-based costs. And the driver must drive an additional number of miles in order to catch up to those variable costs. What if the driver does not drive enough miles to cover both sets of costs?
Alternately, what if the driver covers a large territory and consistently accrues far more miles than necessary to recoup all work-related car expenses?
The year 2020 has provided a perfect set of circumstances to expose the limitations of mileage rate reimbursements. With so many people working from home or making fewer trips for work due to COVID-19, their fixed vehicle costs remain relatively unchanged (except perhaps insurance), but they are not getting much of a reimbursement due to reduced travel.
Yet their employers in many cases expect their personal vehicle to remain in the service of the organization as states reopen and more workers are free to travel by personal vehicle.
How a fixed and variable rate allowance works
A form of vehicle reimbursement exists that can accurately reimburse both sets of costs. In fact, the name specifies both. The IRS calls it a fixed and variable rate allowance. This reimbursement procedure blends the concept of a car allowance to address fixed costs and a mileage rate to address variable costs.
The fixed and variable rate allowance, or FAVR, delivers tax-free payments to employees when administered effectively. 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 allowance, or FAVR program
When an organization chooses to switch to a FAVR reimbursement model, the benefits are often felt quickly. In general, these benefits include
- Customized payments that are accurate to 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
There are also benefits specific to whether you switch from a traditional car allowance or a mileage reimbursement like the IRS rate:
- Switching from a taxable car allowance leverages the tax savings into a higher benefit for employees at a lower cost to the employer
- Switching from paying the IRS mileage rate (or similar) brings greater scalability, protects low-mileage drivers, and increases cost control
A FAVR vehicle program can be challenging to administer at first because of the IRS regulations involved. But with the right guidance and support it can be done cost-effectively.
To learn more about how a fixed and variable rate allowance could work for your organization, you may schedule an exploratory call, use the mBurse FAVR savings calculator, or take a deep dive with our ultimate guide to FAVR reimbursements.