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 each month, regardless of business output. A variable expense changes frequently based on 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.
Examples of fixed costs and variable costs
Examples of fixed costs:
mortgage and loan payments, insurance premiums, rent, salaries, cell phone bills, property taxes, vehicle license.
Examples of variable costs:
hourly wage payments, sales commissions, taxes on income and sales, fuel, raw materials, utilities.
How fixed vs. 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 and variable costs.
When creating a mileage and car allowance program, consider fixed vs. variable expenses. Otherwise, negative consequences may follow:
- Costs exceed the budget
- Insufficient reimbursements
- Over-reimbursements
- Unresponsive to changing expense needs
So what vehicle expenses fall under variable costs vs. fixed costs?
Examples of fixed vehicle expenses
Fixed vehicle expenses are 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
- Depreciation
- Personal property taxes
- Vehicle license and registration fees
Does your company 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. 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 leave this expense out of the car allowance calculation because it is not an obvious 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 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:
- Fuel
- Oil
- Maintenance
- Tires
Why car allowances do not reimburse variable costs effectively
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 violate the law in states that require full reimbursement of expenses.
Why cents-per-mile does not reimburse fixed costs effectively
Mileage rates like 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. And the driver must 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 calls it a fixed and variable rate allowance. This procedure uses a fixed amount to pay fixed costs and a mileage rate to pay 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 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
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 at first because of the IRS regulations involved. But with the right guidance and support this is 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.
