Here are just 2 examples of ways you could monitor the financial performance of your business. Having this in place will give you the comfort of knowing where your business is at and allow you to make timely changes if required. If implemented and monitored it will also result in more profits!
1. Gross Margin
If you are selling products this one is critical. We recently had a client who had signed into a contract to supply product at a fixed price without actually knowing if this price was giving them sufficient margin or knowing what the buffer was in the event that there were changes in raw material prices to them.
Gross Margin is sales minus cost of sales. Cost of sales is effectively the cost of bringing your product to the point where it can be sold. In a distribution type business this may be just the purchase price to you, in a manufacturing business this will be the combined cost of all the raw materials plus labour. By establishing your cost of product you are in a position to calculate your gross margin.
Let’s take the example where John runs a bike shop. He buys and sells bikes and accessories. A particular brand of bike costs John €600 (ex VAT) to purchase from his supplier. In addition John incurs €20 of transport cost to get the bike to his shop. This needs to be included in the cost of goods also.
The bike retails to customers for €999. In this example the retail price will include VAT at 23% and this is never the shop owner’s money. The retailer is only acting as a collection agent of VAT for the Revenue. You therefore have to take the VAT element out of the €999 which the customer pays (€999/123 x 100) and results in a net sales value to the retailer of €813.
Great – but what does that make my margin?
Net Selling Price (€813) minus Cost of Sales (€600 + €20) = €193.
So the Gross Margin is €193 which is a gross margin % of 23.74% (Gross Margin/Net Sales Price).
They say that information is power but when you consider the above it really is in a business sense. By knowing this data for all your products it allows you to make informed decisions. Over time you can get to a position where you have this data by line item which means you could analyse it whatever way is relevant to your business – by product, brand, customer, geographical region for a business with sales reps on the road etc.
You can also determine the impact that discounts may have and also you can focus on those products that return a higher margin.
The gross profit that your business earns is what will cover the fixed overheads (Wages, rent, utilities) and assuming that it covers those the balance is your Profit. By knowing what margin you are earning on your products you will also know whether you are being a busy fool (busy just creating and covering cost) or if you are actually contributing towards Profits.
2. Breakeven Sales
Every business has a level of fixed costs – Wages, rent, rates, utilities etc. These are often referred to as the “below the line” costs while sales and cost of sales are referred to using “above the line”.
A good exercise for all businesses to carry out early in the year would be to budget for what these costs actually are. The best point of reference is by reviewing the prior year accounts or bank statements. Once this list is compiled and you know the costs for the year divide by 12. This gives an estimate of the monthly fixed overhead. The business will need to generate sufficient gross profit to cover this fixed overhead.
Let’s progress the example of the bike shop above. When John sits down at home one evening he works out his costs as follows:
- One full time staff member that earns €25,000 per annum (this is €27,688 including employer PRSI);
- One part time staff member that costs €10 per hour for 15 hours per week. On the face of it this would be €7,800 per annum but you need to add ER PRSI (8.5%) and also allow for holidays (estimate at 8%). This brings the total cost to about €9,140
- Rental cost of €1,000 per month;
- Rates bill of €6,000 per year;
- Telephone costs approx. €200 per month;
- Other costs (cleaning, some advertising, consumables) total approx. €1,000 per month.
Overall these are overheads €69,228 per year. This works out at €5,769 per month or €1,331 per week.
This means that John needs to make €5,769 of gross profit to breakeven every month. Let’s say that the average gross margin % earned across all products sold in the shop is 20% (having carried out the gross margin exercise above you will know this %). This means that the shop needs to generate €28,845 (€5,769/20%) of net sales per month to breakeven. Allowing for VAT (which needs to be added on) this means that the total amount that needs to go into the till each month is €35,479 (I have assumed all products are liable to 23% VAT) just to breakeven! So from a position of having overheads of €5,769 to pay you need to sell €35,479 of product.
You can see how important it is to know this information. In many situations the payment terms for raw materials or product will be spread over a season or financed up front by a short term bank loan (which has to be repaid!). Unless you know the above information it is very easy to fall into cashflow problems as the timing of payments will not always match the timing of sales.
This breakeven sales target can be broken down by week or day and by doing so you will have the comfort of knowing where your business stands.
Keep an eye on our website in the coming weeks as we will have some easy to use free download calculators and tools which will help you with the above.