Calculating Costs

With over 18 years of public accounting experience, Hershy Donath guides and advises business owners and other stakeholders. Here, he shares some of the metrics critical to running a successful business.

So, your company is offering an exceptional product or service. The customers are flocking to your door, and you know you’re making lots of money—just look at those healthy sales numbers, right?

Well, not so fast.

Just focusing on your bottom line may not be enough to keep your business viable and healthy in the long term. To optimize, grow, and scale up a business, a business owner needs to be aware of certain key metrics.

Which of your products are the most profitable? How much of your resources should be tied up in inventory? Does the business have enough cash to remain stable? A business that flies by the seat of its pants is not going to fly very far. By using financial metrics, a business has a roadmap to follow that can direct it toward profitability.

Metrics are numbers that tell you important information about your business’s processes. They provide accurate measurements of how successfully your business is operating and are the tools that a business owner uses to make critical business decisions. Think of metrics as the barometer of your operations.

Note: Business metrics range from simple numbers to extremely complex numerals and logarithms. This article is intended as a basic introduction to metrics.

Gross profit

Revenue is nice, but it’s not profit. Revenue reflects how much money a business is pulling in from the sale of goods. It’s the feel-good numbers that represent proceeds coming into your business. But revenue doesn’t tell the whole story. Gross profit reflects how much money you are actually earning from your sales after factoring in the cost of goods sold, i.e., the direct costs of producing the product you sell or service you offer. This is not your net profit, as it does not include costs not directly associated with production. Nevertheless, this metric is the key driver of many operational decisions.

Costs

Now let’s talk about costs. There are all kinds of costs involved in running a business, and they are categorized as “variable” or “fixed” costs. Both variable and fixed costs have a large impact on profit.

Variable costs change as the quantity of the goods or services a business produces changes. Examples are the costs of raw materials, direct labor, and freight.

Fixed costs are just that—fixed, irrespective of how much product you produce. They include rent and the cost of insurance, phone, internet services, and indirect and administrative salaries.

What would happen if your primary customer decided to close his business and run off to pursue his dreams? Let’s say it would mean a 50 percent hit in your sales. But you would still have to pay the same rent and insurance bills, since those are fixed costs.

What if you add a night shift in your existing factory? You would increase your variable costs, such as the costs of direct labor, raw materials, and electricity, but your rent and CFO’s salary (fixed costs) would remain the same.

A solid understanding of your business’s fixed and variable costs is a necessity; it will allow you to identify your profitable price level and will tell you what your break-even point is.

The break-even point

Your break-even point is defined as how much product you’ll have to provide to make your gross profit or margin equal your fixed costs. When a business is able to separate its fixed and variable costs, it can calculate its break-even point.

Balancing the books

Shira is a speech therapist who charges her clients for 45-minute sessions. Her break-even point is how many units she needs to provide in order to cover all her costs.

Let’s say Shira charges $90 per 45-minute session. Her variable costs, such as gas, parking, tolls, and supplies amount to $30 per session. Shira also has fixed costs, such as the cost of her answering service, her cell phone bill, professional association fees, and administrative expenses, which amount to $900 per month.

What is Shira’s break-even point, i.e., how many 45-minute therapy sessions does she have to provide to cover her costs?

To figure this out, Shira needs to calculates her gross profit or margin per unit, which is $60 ($90 – $30 = $60). She’ll then divides her fixed costs by her margin per unit to arrive at her break-even point ($900 / $60 = 15).

Shira needs 15 sessions each month to break even. Each session after that, Shira can expect to walk away with $60 after her variable costs.

Armed with this information, Shira can schedule sessions and work efficiently toward her financial goals.

Next week we’ll discuss profit metrics including receivables, inventory, and data.