Working out the finances of a small business can seem scary for entrepreneurs new to the neighbourhood, but it doesn’t have to be complicated if you know the basics.
There are a few components you need to know and understand, such as turnover, cost of sales, work in progress (if you are in manufacturing), variable expenses, fixed costs, mark-up, gross profit, costing, tax and profit.
Okay, that all sounds very overwhelming but let’s break it down step by step.
In this post, we will explore the cost of sales (CoS) component, and focus on costing itself. These two aspects are connected; costing is calculating what the actual cost of the product is, whereas CoS is the calculation of the cost of the sale.
1. Cost of Sales
The name of this component might seem self-explanatory, but it causes even the most seasoned of tradesman to be confused sometimes.
CoS refers to the cost of only the item that has been sold. For example, if I want to sell a coffee mug, what will the cost of that mug be? The cost, in this case, would be the purchase price PLUS the cost of transport of that mug to the shop where someone will be able to buy it.
Here’s a simple example:
· You buy 100 mugs for R500.
· The cost of the delivery of the mugs is R100.
· The cost of one mug is, therefore, R6. This is how we worked it out:
(R500 + R100)/ 100 = R6.
· So, when you sell one mug, the cost of that sale (CoS) is R6.
When calculating the CoS for the business as a whole, you need to work out how much stock was sold. This calculation includes the total purchases, delivery costs, and how much stock you started and finished with: (opening stock + purchases+ delivery costs)- closing stock = CoS
When calculating for a manufacturing business, the CoS will also take work in progress into account.
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For this exercise to have its desired outcome, we will need to know what to sell our product or service for (selling price or SP), and what gross profit percentage (GP %) will be realised in the business process.
There are different models for different types of businesses. Let’s take a look at three simple costing models.
You are selling time. This is the only model where the variable cost and fixed costs are included in determining the cost of your time. In this model we assume that you are the only person selling time. You will sell your expertise in hourly units.
Doctors and lawyers could also sell 15- or 30-minute units.
The GP % in a service business is always 100%.
Simple retail business:
In this business model, you determine the cost - not the overheads - of each item, and based on a mark-up policy, decide on the selling price. This will help you establish the desired GP %.
The following model uses stationery items to illustrate its purpose.
In your business, you may have groups of products with different mark-up policies, and you may want to design a table for each of those groups.
For your information:
· SP = CP x (1 + mark-up %)
· Mark-up % = (SP – CP)/ CP
· GP = SP – CP
· GP % + (SP – CP)/ SP
The manufacturing model can be quite complicated, and it may be wise to engage with a costing specialist or mentor to determine accurate manufacturing costs, including wages, electricity, water, rent and machine costs.
However, some manufacturing businesses do not have complicated financial situations.
For instance, if you cook and sell fast foods, you only need to use a model like the one below for each of the items you make, such as a hamburger. (This can be seen as the simplest form of a manufacturing business)
Be reminded that entrepreneurs take calculated risks
For this reason, it is important to know what risks are out there - as far as the market, production, selling processes, and financial risks are concerned.
Keeping this in mind, having a clear mark-up policy, and staying on top of your CoS and GP % can help to reduce the financial risks to your business.
If any these processes overwhelm you, get in touch with an experienced mentor or business advisor to assist you. Remember, however, to be clued up enough to understand what they did and why they did it.
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