What good is having a business you love if you can’t pay the bills or feed yourself? Some people may find their passion and know just how to make things flow in order to deliver their product flawlessly to the consumer, yet still fail as a business. That is because proper money management is vital to your business’ survival. In fact, some may argue that money is what makes the business.
To succeed financially, you need to know where your money is going and what you are getting in return.
You need to have a clear understanding of your cost of goods and margin, as well as fixed and variable costs in order to make informed decisions.
So, what are all these costs and what do they mean?
Cost of goods is pretty straightforward. It is the price you pay for the product you are selling. So lets say you are planning to sell T-shirts and each one costs you $10. If you buy 100 shirts for resale. Your Cost of Goods Available for Sale (COGAS) is now $1,000.
Let’s assume you opened shop and the first month you sold 40 t-shirts. Your COGAS, or inventory, is now $600 and your Cost of Goods Sold (COGS) is also $400.
Unless you’re trying to go bankrupt, you’re probably selling your shirts for more than you buy them. So, let’s say you’ve marked up each t-shirt to $15. That means for those 40 you sold the first month you business earned a revenue of $600 with a COGS of $400, leaving you with a gross margin of $200.
That’s great, right?! You made $200 your first month! Or did you?
Covering basic business expenses can be your first major hurdle before you achieve profitability. These are what your accountant would call Fixed Costs or what many may think of as G & A (though not all G & A are necessarily fixed costs).
What are Fixed Costs?
Fixed costs are those costs which you would have if you did not sell a single unit, think rent. For example, if you have a storefront that you rent for your t-shirt business and your rent is $1,000 per month, you still owe $1,000 even if you sold nothing at all.
Some costs can be slightly ambiguous like utilities. If your store is open fewer days then your bill will be lower.
While utilities may fluctuate, they generally they are regarded as fixed. The same can usually be said about wages unless hours worked directly correspond to units produced or sold (that can get really complicated and is best served as a standalone article or series).
All in all for now just think of it this way, if you sell could sell nothing one month and sell your entire inventory the next without the cost changing substantially on its own, then consider it a fixed cost.
What Does That Look Like in Practice?
For this scenario lets say you have rent, utilities and one part time employee as its fixed costs.
Suddenly that $200 gross margin doesn’t look so good. You’re short $3,100 this month.
Why So Gloomy?
A lot of articles out there want to give you a feel-good feeling, so they paint a picture of how you’ll be making $10,000 in your pajamas watching TV. When you inevitably don’t succeed then you think that it is something you did wrong, and you really need to go read more of their advice to see how they did it. Worse still, you need to buy their program and sign up for their coaching.
That’s not me. I want you succeed now and keep on succeeding. This is the harsh truth of small businesses. Owners see that $200 margin and think they are making money, then get stressed and upset because they don’t know why they can’t cover the bills.
“I’m getting a 50% markup, why is my account overdrawn?”
How Much Income do I need?
You know that you have fixed costs to cover and now you know the total you’re spending on them each month. So now you only need to make that $3,300 right?
Not quite. To figure out the total sales we need, we have to find what is called the Contribution Margin. For that you need the cost of goods and the variable costs.
Variable costs are those costs which fluctuate as a direct result of increasing or decreasing sales volume.
Commission is a great example of this. If you pay your sales staff an hourly rate plus commission, then that commission would be variable costs.
For this example, we’ll say that you pay your employee $1 for every sale he or she makes. The 40 t-shirts that were sold have a variable cost of $1 each in addition to the $10 COGS. So that leaves you with a contribution margin of $4 for ever unit. (Sales price -COGS – Variable Cost).
Contribution margin is the amount of income which is over and above the cost of sale. This is used to find your Break Even Point or a target income.
Break Even Point
We have established that the fixed expenses equal $3,300 per month and that the contribution margin is $4. Now to find the breakeven point you can simply divide fixed costs by $4.
This gives us 825, which means that you will need to sell 825 t-shirts to come to a net income of $0. Meaning, your business paid all of its bills and neither lost nor gained any income.
So far, we have not included a salary for you, the owner. Often the owner of a small business doesn’t get to take a salary for the first 3-5 years. Still, you certainly will want to get paid and knowing what you need to get there is important.
Let’s say you want to earn at least the median income in the US which is roughly $2,700 per month. That formula would look like this (fixed costs + target income)/Contribution margin. In our case that would be ($3,300+$2,700)/$4 = 1,500 t-shirts that you need to sell per month. For perspective, this would be $22,500 in revenue.
Adjust Your Expenses
You may think that 1,500 t-shirt sales per month seems impossible when you’re just starting out. Truthfully it will likely take a lot of time and effort to ever reach that mark. Your small business may need to sustain at a loss for an extended time before even consistently reaching the breakeven point of 825 units per month.
There are some things you can experiment with or consider that may help you reach your goals faster. After all, you picked an item you are passionate about for your business. You know the ideal price points and have a good idea of what drives sales.
Can you raise your prices? If you increased to $16 per unit then your breakeven point would drop to 660 t-shirts and your target income would drop to 1,000 units.
Does the $1 per sale actually cause any additional sales? Can you reduce this or other variable costs?
Would spending more actually reduce your time to breakeven? That may sound crazy, but as you know you have to spend money to make money. Does your target market respond well to paid advertisements? Keep in mind that attracting a new customer is multiple times the cost of retaining, so an upfront investment in ads may kick start your revenue and save on expenses later. This will increase your fixed costs, however, so carefully weigh your options.
Can You Say That Again? But Try Making Sense This Time
Ok, I’ve thrown out a lot of terms and some math that may seem all over the place. While its usually best to hire an accountant or bookkeeper, you still need to know how everything works for strategic planning.
Here’s the Rundown
You have recurring costs that don’t change based on sales volume. You have some that do. You need your sales price to be low enough to still attract customers, but high enough to make a margin you can work with. You need to identify how many units you have to sell to reach your goal and build a strategy around that.
Revenue does not equal profit, and money in the bank doesn’t mean usable cash. Next time we will be discussing income verses cash flow and why that’s important to you as a business owner.