The value of getting your costs right

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19 / Mar / 2012

Understanding how much it costs you to provide your product or service to your customers is vital to running a profitable business. This case study will help you understand why.

What are your costs?

Costs are sometimes referred to as direct costs, cost of goods sold (COGS), or variable costs. The factors you need to consider will vary according to your business model:

• If you sell a product, you need to factor in the cost of buying the product, plus everything that goes with preparing it for sale, such as the freight, storage, currency exchange, and importation

• If you manufacture goods (rather than buying them to re-sell), your costs are the raw materials, packaging components, labour, equipment, storage and so forth, as per selling a ready made product

• If you sell a service or jobs, it’s the cost of direct labour i.e. those who deliver the service and materials

These figures exclude overheads such as rent, administration costs and wages, which are covered by your profit margin.

More sales don’t always mean more profit

It’s easy to think that selling more products or services will fix lack of profit and cash flow. But that’s not always what happens, as this case study shows.

“ It’s easy to think that selling more products or services will fix lack of profit and cash flow. But that’s not always what happens. ”

For example, if a business had yearly sales of $1million, costs of 70 percent ($700,000), overheads of 30 percent ($300,000), and paid $10,000 in interest per annum (to cover debt collections), it would be running at a loss of $10,000 per year. ($700,000 + $300,000 + $10,000 = $1,010,000, which is a loss of $10,000).

If sales grow 30 percent to $1.3million, but costs and overheads remain the same, the scenario gets worse, not better: costs of 70% become $910,000, overheads of 30% become $390,000, and the interest payable increases to $12,000. ($910,000 + $390,000 + $12,000 = $1,312,000, which is a loss of $12,000)

Why has the interest gone up? In the example of this business the debt collection days are running at just under 53 (a recent national average per Dunn and Bradstreet) and it has an overdraft of $100,000. If it sells more and the debt collection days remain the same it will need to borrow, waiting for customers to pay more money, in this case an extra $29,000.

In real life, the decline in profit may actually be greater, as the overheads would likely go up due to increased spend on advertising and marketing involved in achieving the extra $300,000 in sales.

Cutting costs improves profit

If we reduce costs for this business by just 2 percent, the profitability changes dramatically.

Say yearly sales remain at $1million, but the costs are reduced to 68 percent ($680,000), overheads are still 30 percent ($300,000), and interest declines to $8,690 (less funds are required to pay for the costs), the profit becomes $11,310. ($680,000 + $300,000 + $8,690 = $988,690, which is a profit of $11,310).

That puts this business owner more than $21,000 in front, compared to scenario 1, above, and more than $23,000 ahead compared to scenario 2.

This minor reduction in costs would likely be a lot less expensive to achieve than a $300,000 increase in sales.

To add to this, if we could reduce the debt collections days from 53 to 43, it would mean a $29,340 reduction in borrowings and a further $1,956 interest saving.

This is why it’s so vital to keep a keen eye on your costs and overheads. A small reduction in them can far outweigh a large increase in sales.

Source: Flying Solo 28/2/12