The Costs of Operation

1. The Costs of Operation Business Management

2. Today’s Objectives Objective Essential Questions Identify the cost of operations How can you calculate cost of operations? How can you calculate cash flow?

3. Costs The costs of starting and operating a business are divided into the following categories: • Startup costs • Cost of goods sold • Operating costs, including fixed costs and variable costs

4. The Costs of Operation • Startup 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.

5. For a hot-dog stand, startup costs might look like this: • Hot-dog Cart $1,500.00 • Business License 200.00 • Starting Supplies (hot dogs, buns, mustard) 300.00 • Business Cards & Fliers 50.00 • Telephone Answering Machine 100.00 Total Startup Costs $2,150.00

6. Operating Costs • The operating costs of a business are those costs that are necessary to operate the business, not including the cost of goods sold.

7. Operating Costs • Operating costs can almost always be divided into six categories • Utilities (gas, electric, telephone) • Salaries • Advertising • Insurance • Interest • Rent

8. Operating Costs • Operating costs are also called overhead.

9. Operating Costs • Fixed 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.

10. Operating Costs • Variable 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.

11. Operating Costs • An example of a variable cost might be electricity. • A flower shop, for example, stores many more flowers in its refrigerators around Easter or Mother’s 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.

12. Cost of Goods or Services Sold • The 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.

13. An example of the cost of goods sold of a turkey sandwich is shown in the following table:

14. Gross Profit Per Unit • Once 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.

15. The equation to calculate gross profit per unit: Selling Price – Cost of Goods Sold = Gross Profit per Unit

16. Calculating Gross Profit Per Unit • In the case:

17. Cost of Goods Sold • As an entrepreneur, you must keep the cost of goods sold secret. • If customers learn your cost of goods sold, they’ll use that information to try to negotiate a lower selling price.

18. Profit • Gross 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.

19. Profit • The Equation for calculating Profit is: Gross Profit – Operating Costs = Profit

20. Profit Per Unit • It 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 unit • In this example, the entrepreneur is earning a profit of $12.50 for each unit (product) sold. Profit ÷ Units Sold = Profit per Unit

21. Tracking Your Cash Flow • An 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.

22. Cash Flow • Cash 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.

23. Cash Flow • Discrepancies 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.

24. Noncash Expenses • The 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 aren’t actually physically spending that amount of cash. • You don’t hand anyone cash when you record a depreciation expense on your income statement.

25. Noncash Expenses • Depreciation is a noncash expense because there’s 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.

26. Your Cash Position • As 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 doesn’t pay until August, the income statement will show the sale in June and the cash flow statement will show the sale in August.

27. Cash Flow Statement

28. Risking Your Cash on Inventory • An 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.

29. Risking Your Cash on Inventory • There are two other risks with inventory: • Storage costs and • Pilferage

30. Risking Your Cash on Inventory • You 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, Barney’s (the famous New York clothing store) has 7% pilferage rate, which contributed to driving it out of business.

31. Risking Your Cash on Inventory • There is also the danger that you’ll 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.

32. Forecasting Cash Flow • As you get your business off the ground, you’ll need to prepare monthly cash flow projections to make sure you’ll have enough cash coming in to pay your bills.

33. 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 can’t 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.

34. 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.

35. Forecasting Cash Flow • You can’t necessarily be sure these projections will be accurate, but do them anyway. • Review and update them constantly.

36. Cumulative Cash Flow Graph • It is suggested that entrepreneurs should plot the business’s 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.

37. Sample Cumulative Cash Flow