5.02 – Understanding Costs & Budgeting In Your Business
Evaluating Costs Relative to Sales Revenue
When assessing whether a cost is too high, it’s essential to compare it against your sales revenue. For example, if your business’s salaries and wages expense is $225,000, you can only determine if this is excessive by comparing it with your annual sales revenue. This approach applies to all your expenses.
In an ideal scenario, customers would be willing to pay any price you set, covering your costs and ensuring a profit. In this perfect world, your costs would always be under control. However, in reality, customers are sensitive to prices. You need to set your prices high enough to cover your costs and make a profit, without driving customers to cheaper alternatives.
Cost Control in Context
Cost control is a crucial part of the broader management function of revenue, cost, and profit analysis. This analysis should start with your Profit and Loss (P&L) report, also known as the income statement. This statement summarizes your sales revenue and expenses for the year.
Suppose your business operates as a pass-through income tax entity, where taxable income is reported by the shareholders on their personal tax returns. A typical income statement will compare the current year with the previous year, showing expense percentages relative to sales revenue.
Cost control can be tackled at three levels:
- Overall Business: Looking at the entire business.
- Profit Centers: Analyzing different streams of revenue within the business.
- Specific Costs: Examining individual expenses.
Sales Revenue Change
An increase in sales revenue is beneficial, but only if costs don’t increase proportionally. It’s useful to know how much of the sales revenue increase is due to volume versus price changes. In some cases, sales volume and price increases contribute differently to overall revenue growth.
Cost of Goods Sold and Gross Margin
For product-based businesses, the cost of goods sold is deducted from sales revenue to determine the gross margin. This gross margin is profit before any other expenses are deducted. Understanding the behavior of this expense and its impact on gross margin is crucial.
In our example, sales volume increased by 20%, and sales prices by 7.7%, resulting in a 40.2% increase in gross margin. This scenario highlights the importance of analyzing the contributions of sales volume and price changes to overall profit.
Employee Costs
Evaluate whether your employee costs are reasonable relative to your sales revenue. For example, if your salaries, wages, commissions, and benefits account for 22.7% of sales revenue, assess if this ratio is acceptable. Consider whether your employee costs could be reduced without impacting sales capacity and revenue.
Advertising and Sales Promotion Costs
Advertising and sales promotion costs should be evaluated based on their impact on sales. Keep track of which campaigns are most effective and ensure that these costs are justified by the revenue they generate. A common benchmark for this expense is around 7% of annual sales.
Depreciation Expense
Depreciation expense reflects the cost of owning fixed assets. Understanding the methods of depreciation (straight-line or accelerated) and their impact on your financial statements is essential. Depreciation is a real cost, representing the wear and tear of fixed assets over time.
Facilities Expense
Facilities expenses cover the cost of physical space needed for business operations. This expense should be reported separately in the income statement. Benchmarks, such as sales per square foot, can help evaluate whether your facilities expense is in line with your sales revenue.
Other Expenses
Miscellaneous costs, while small individually, can add up and impact your overall profit. Regularly review these costs to ensure they are necessary and reasonable. Set limits on how much can be recorded in miscellaneous expense accounts to maintain control.
Interest Expense
Interest expense, the cost of using debt, should be analyzed in the context of your overall financing strategy. Ensure that your interest rates are accurate and reflect the terms of your loans.
Comparing P&L with Balance Sheet
Regularly compare your P&L numbers with your balance sheet to ensure consistency. Key ratios, such as accounts receivable to sales revenue and inventory to cost of goods sold, can help monitor the health of your business. Understanding these ratios helps prevent solvency issues and ensures efficient use of capital.
