The financial freedom you envision as a business owner has its start in knowing what your current results are from the “Covering Your Cost Calculations.” These seven formulas are the fastest way to increase your understanding of what it costs you to do business.
Once you know what it costs you to do business, you can decide which costs you are willing to live with and which costs need to be reduced. Your Profit Plan is how you frame your cost structure to earn the profits you require for the return on the investment you have in your business.
Fail to do this, and you will never gain control over the costs of your business. Unmanaged costs are the leading cause for businesses running out of cash, paying for costs that are too high on their way to going out of business.
Making money starts with accurately knowing what your costs are across your business. Another basic business truism is that money is “hard to earn and easy to lose.” The best way to guard your money with care is by knowing the actual costs of your business so that you can price your products and services to make money.
The most basic business calculation to perform is the “Covering Your Cost Calculations,” which represent the starting point for achieving financial freedom. Use these formulas to increase your understanding of what it costs you to do business.
Financial freedom is not something that happens randomly for the fortunate few; it’s something that you engineer by knowing the math behind your business costs. Below are the most common Cover Your Cost Calculations:
1. Revenue per “ALL” Employees
Net Sales / # of Full-time Employees
A company earning $110,000 in sales per employee will struggle against a company earning $1,100,000 in sales per employee. This is because the more employees you have on your payroll, the higher the risk of costly mistakes, so you need to push this number up continuously.
2. Breakeven Sales Point
Fixed Costs/(1-(Variable Costs/Sales))
Should that company have $300,000 in fixed costs and $1,800,000 in variable costs, it must generate $1,650,000 in sales to breakeven. Should they generate $1,485,000 with no change in operating expenses, they will lose ($165,000) because sales came in below breakeven and expenses didn’t change.
3. Average Daily Costs to Do Business
COGS + SG&A / # of Days
If your average cost per day is $105,000 and you take in $110,000 in average sales then you’re $5,000 ahead. If the next day cost structure doesn’t change, and you only take in $99,000 then you’re down ($6,000) for the day and ($1,000) for the two days because you took in less on day two than you spent. This is why you need to pay attention to changes in sales so you can make sure you’re costs are adjusting before you did yourself into a difficult hole to dig out of.
4. Overhead Absorption Rate
Total Fixed Costs / Total Variable Costs
An Overhead Absorption Rate of 0.17 means you are planning to spend $374,000 in SG&A expenses on COGS of $1,800,000. Spend more than your OAR targeted $374,000 and you will miss your Operating Income target of $100,000.
5. Cost to Do Business
Gross Sales – Net Income
Gross Sales of $2,250,000 and net income of $100,000 is the same as $1.00 – $0.04 = $0.96 or your cost to do business on every dollar sold. Put another way, you spent $2,150,000 chasing after the $100,000 you earned from the $2,250,000 in Gross Sales. Put another way, every cent you don’t spend is a penny that drops straight to your bottom-line.
6. Average Net Proft per Manager
Net Profit / # of Full-time Managers
A company earning $100,000 in Net Profit is averaging $20,000 in bottom-line profits through the work of its 5 managers is going to struggle against a company earning the same amount with fewer managers. This is because the more managers you have on your payroll, the higher the risk of bureaucracy and employee frustration when you have more bosses than workers.
7. Owners’ Compensation Ratio
Total Owner’s Compensation / Net Income
A ratio of 0.3 means that for every dollar of Net Income, the owner is paying themselves $0.30 of each profit dollar after everyone else has been paid. Put another way, the owner is holding onto $0.01 for every $1.00 sold and collected.
8. New Investment Validation Calculation
Planned Spend / Net Profit Margin
A planned investment with a cost of $50,000 and a 10% targeted Return on that Investment. I.e., you have a goal of earning 10% in Net Income from Net Sales. The sales value of that investment is $500,000 ( $50,000 / 0.10 = $500,000). This means you will need to generate $500,000 in sales to return your $50,000 investment. The core question is, how long will it take to generate the $500,000 in sales?
When you can do the math for any area of your business, you can change the results for that area by changing the inputs used in its equation.