If you don’t know your costs, how do set your prices? How do you know what products or services are making the most money for you? Are you letting your competition set your prices? Once you know your costs, then you will be able to determine your profit margin by setting a reasonable price that covers all your costs and gives you return on investment (ROI). So what are costs? Well, there are two kinds: direct and overhead. Direct costs are costs you can relate directly to what your business produces and overhead costs are indirectly related. Let’s start with some examples of overhead: office rent, management salaries, advertising & utilities. For product related businesses, direct costs consists mostly of materials or product purchases and labor. With service businesses direct costs are mostly labor costs plus any vehicle costs like fuel and maintenance (if the business uses vehicles to deliver the service – otherwise it is an overhead cost).
Determining your monthly operating costs is greatly impacted by your ability to distinguish a cost (which goes on the P&L) and an asset (which goes on the balance sheet). For example, let’s say you decided to get into a retail service business but you want the support of a national marketing campaign, so you purchase a franchise. You sign a 15 year agreement and pay $12,000 in upfront franchise fees. Is this a cost of doing business or a benefit (asset)? Your accountant should be able to help you sort through your costs. (If you don’t have an accountant, we’d be glad to help!) Also, don’t forget to include annual & quarterly costs, like your chamber membership. To include these costs in a monthly analysis, just divide by their time period.
What about break even? It’s the point at which your sales = total costs. If you take your break even number and divide it by the price or average price of what you sell, then it will give you the number of units you need to sell to cover your costs, and any sales past that point would be profit. If you have different price points, you can look at the most likely sales mix and determine how many units at each price point in the mix, you need to sell to break even.
Determining costs, profit, pricing & break even are great planning tools. These figures are necessary in creating the initial performance projections and the financials that are the heart of any sound business plan.
