Too often, small business owners are overly optimistic with their financial projections because they can’t properly calculate revenue and expenses. Understanding four key financial terms is one of the first steps to creating more accurate financials, mitigating future risk, and keeping your doors open for business day after day.
1) Cost of Sales (Cost of Goods): Knowing your Cost of Sale (Cost of Goods) will ensure you include all relevant costs to create your product or service, and ensure you sell it with an adequate markup to make a profit.
For example, a custom dress maker would add up the cost of fabric, a sewing machine (life), energy to run the machine, thread, needles, labels and labour. From that, she may determine the cost to make one dress is $25. She can then set an appropriate price to ensure a profit is made. Too often owners who sell handmade goods underestimate the cost of goods sold, especially in terms of labour costs, and sell their products at a price point that is not sustainable for the business.
2) Unit of Sale: Knowing what a unit of sale looks like can help an owner visually break down the number of units that need to be sold.
For example, a small coffee shop can estimate that a unit of sale is equivalent to the price of a small coffee $5 and small baked good $3. Therefore, the estimated average unit of sale is $8. Last month, the coffee shop had fixed costs of $1,000 and variable costs of $2,500, for a total monthly expenses of $3,500. Knowing those fixed costs, it’s clear that 438 units of sale is the minimum the coffee shop must do in a month to reach its breakeven point.
3) Breakeven Point (BEP): The point where revenue and expenses net to zero.
Small businesses will generally have a few target BEPs.
For example, the first BEP will be where revenue and fixed expenses net to zero. Usually this means the owner is not being paid a salary. The fixed costs are covered, however, such as rent, utilities, and supplies to keep the business operating.
The second BEP will be where revenue and fixed expenses + low variable expenses net to zero. Low variable expenses is the bare minimum the owner needs to cover basic living expenses. For example, fixed expenses cover the business rent, utilities and supplies. The low variable expenses covers the owners rent and food costs.
The third BEP will be where revenue and fix expenses + higher variable expenses net to zero. At this stage, the owner will possibly have a contracted worker, additional marketing resources, and possibly a small increase to his or her salary to live more comfortably.
4) Cashflow: Once you have determined your cost of goods sold, and thus the selling price, as well as the average unit of sale, you can then begin to build an accurate projection of your revenues. Revenues less expenses (fixed and variable) equal net income. Small businesses generally do not have enough historical data to mitigate risk, thus creating an accurate cashflow is imminent for survival.
Taking the time to understand and plan around these four financial concepts is essential for any small business owner. If you ever have questions about these or other financial concepts, don’t hesitate to contact a professional accountant.