The Costs of Operation

Business ManagementThe Costs of OperationTodays ObjectivesObjectiveEssential QuestionsIdentify the cost of operationsHow can you calculate cost of operations?How can you calculate cash flow?CostsThe costs of starting and operating a business are divided into the following categories:Startup costsCost of goods soldOperating costs, including fixed costs and variable costsThe Costs of OperationStartup costs are the one-time expenses of starting a business. They are also called the original investment.In a restaurant, for example, this would include:Stoves, food processors, tables, chairs, silverware, and other items that are not replaced on a regular basis.Also included might be the on-time cost of buying land and constructing a business.For a hot-dog stand, startup costs might look like this:Hot-dog Cart$1,500.00Business License 200.00Starting Supplies (hot dogs, buns, mustard) 300.00Business Cards & Fliers 50.00Telephone Answering Machine 100.00Total Startup Costs$2,150.00

Operating CostsThe operating costs of a business are those costs that are necessary to operate the business, not including the cost of goods sold. Operating CostsOperating costs can almost always be divided into six categoriesUtilities (gas, electric, telephone)SalariesAdvertisingInsuranceInterestRentOperating CostsOperating costs are also called overhead.Operating CostsFixed costs are operating costs that stay the same, regardless of the range of sales the business is making.Rent can be an example of a fixed cost.Whether a shoe store sells 200 or 300 pairs of shoes in a month, it still pays the same rent on the store, so the rent is considered a fixed cost.Operating CostsVariable costs are operating costs that change, depending on the volume of sales, but cannot be assigned directly to the unit of sale.If cost can be assigned directly to a unit of sale, it should be viewed a part of the cost of goods sold.Operating CostsAn example of a variable cost might be electricity.A flower shop, for example, stores many more flowers in its refrigerators around Easter or Mothers Day.The refrigerators require more electricity to cool all the flowers.Electricity, therefore, is an operating cost that is higher when the store is selling more flowers.Cost of Goods or Services SoldThe cost of goods sold can be thought of as the cost of selling one additional unit of a product.The cost of services sold is the cost of serving one additional customer.The total cost of goods sold increases as the number of customers served increases. An example of the cost of goods sold of a turkey sandwich is shown in the following table:ItemAnalysisCost per SandwichTurkey 4 oz.$2.60 per pound$0.65Bread large roll0.32 per roll 0.16Mayonnaise 1 oz.1.60 per 32-oz jar0.05Lettuce 1 oz.0.80 per pound0.05Tomato2.20 per pound0.28Pickle 0.20 per pickle0.05Wrapper10.00 per 1,0000.01Cost of goods sold$1.25Gross Profit Per UnitOnce you know your cost of goods sold and have defined your unit, you can calculate your gross profit per unit.The cost of goods sold of the sandwich, subtracted from the price customers pay for the sandwich, equals the gross profit per unit for the sandwich.The equation to calculate gross profit per unit:Selling Price Cost of Goods Sold = Gross Profit per UnitCalculating Gross Profit Per UnitIn the case:

ItemCostPrice of sandwich$4.00Cost of goods sold-1.25Gross profit per sandwich$2.75Cost of Goods SoldAs an entrepreneur, you must keep the cost of goods sold secret.If customers learn your cost of goods sold, theyll use that information to try to negotiate a lower selling price. ProfitGross profit only subtracts cost of goods sold (for a product business) from revenue.It does not take into account the operating costs of running a business.To figure profit, the entrepreneur must subtract operating costs from gross profit.ProfitThe Equation for calculating Profit is:

Gross Profit Operating Costs = ProfitProfit Per UnitIt is also important to know how much of the sale of each unit is profit.An easy way to calculate profit per unit is to divide total units sold into profit, such as the example below:$125.00 total profit 10 units sold = $12.50 per unitIn this example, the entrepreneur is earning a profit of $12.50 for each unit (product) sold.Profit Units Sold = Profit per UnitTracking Your Cash FlowAn entrepreneur cannot effectively guide a businesses daily operations using the income statement alone.It is also important to use a monthly cash flow statement to track the cash going in and out of the business.Cash FlowCash flow is simply the difference between the money you take in and the money you spend.Remember, cash is the lifeblood of your business.If you run out of cash, your business is dead.Without cash on hand, you may find yourself unable to pay important bills even if your income statement says you are earning a profit.Cash FlowDiscrepancies between cash on hand and projected profits on an income statement occur because there is often a time lapse between when you make a sale and when you receive the cash for that sale.Noncash ExpensesThe income statement can also distort your cash picture because it may include noncash expenses like depreciation.When you depreciate an asset, you deduct a portion of its cost from your Income Statement.But you arent actually physically spending that amount of cash.You dont hand anyone cash when you record a depreciation expense on your income statement.Noncash ExpensesDepreciation is a noncash expense because theres no cash going out of the business.If depreciation is deducted from an income statement, then the income statement no longer accurately reflects how much cash the business is really holding.The cash flow statement requires you to add back the amount of depreciation that was deducted from the income statement.Your Cash PositionAs an entrepreneur, you need a cash flow statement to depict the cash position of your business at specified points in time.A cash flow statement records inflows and outflows of cash when they occur.If a sale is made in June but the customer doesnt pay until August, the income statement will show the sale in June and the cash flow statement will show the sale in August. Cash Flow StatementCash InflowsSales, 3/1-3/31$65,400Total Cash Inflows$65,400Cash OutflowsCost of Goods Sold$29,360Factory Rent and Utilities8,000Salaries and Administrative12,000Sales Commissions6,540Total Cash Outflows$53,900Net Cash Flow Before Taxes(65,400-$53,900) = $11,500Taxes($11,500 * .25)= 2,875Net Cash Flow$8,625Risking Your Cash on InventoryAn entrepreneur takes a risk every time she/he spends cash.If you buy inventory, for example, you take the risk that no one will buy it or that no one will be willing to spend what you paid for it or more, so that you can make a profit.Risking Your Cash on InventoryThere are two other risks with inventory:Storage costs andPilferageRisking Your Cash on InventoryYou have to make sure you can sell the inventory at a price that will cover any costs of storing it.You also need to cover the cost of theft by employees and customers.For example, Barneys (the famous New York clothing store) has 7% pilferage rate, which contributed to driving it out of business.Risking Your Cash on InventoryThere is also the danger that youll invest in inventory because you expect to receive cash from customers who owe you money (accounts receivable).Be aware that a percentage of your accounts receivables will probably never be collected.These are all reasons to keep an ongoing cash flow statement for your business.Forecasting Cash FlowAs you get your business off the ground, youll need to prepare monthly cash flow projections to make sure youll have enough cash coming in to pay your bills.Forecasting Cash Flow You can forecast cash flow in two steps:Project your cash receipts from all possible sources. Remember, orders are not cash receipts because you cant guarantee that every order will yield cash. Some orders may be canceled, some customers may not pay up. Cash receipts are checks that you are sure are going to clear.Forecasting Cash Flow You can forecast cash flow in two steps:Subtract from these projected cash receipts any expenses you expect to have. Cash expenses are only those expenses you will actually have to pay during the projected time period.Forecasting Cash FlowYou cant necessarily be sure these projections will be accurate, but do them anyway.Review and update them constantly.Cumulative Cash Flow GraphIt is suggested that entrepreneurs should plot the businesss cumulative cash flow on a simple graph to see how the business is doing.The goal is to eventually see cash flow increase.The following example shows a business that needs to raise financing to meet its negative cash flow.Sample Cumulative Cash Flow