Everything you sell will have a cost associated with it. If it’s a product then you’ll have the cost of the components of each product, the cost of putting them together, then maybe the packaging and any in-box collateral, the delivery costs, warranty, storage, import duties and so on.You also have these costs if you sell a service, but maybe not so much.
Make a list of all the different items of cost that you have to pay to get your product or service in the hands of your customers. These are your fixed costs - those that cannot be avoided. If you sell each product for £100 and your fixed costs are £60 per product, then you make a gross profit of £40, or a gross margin of 40%, each time a product is sold.
Easy peasy? As my French teacher says.
After your fixed costs you have discretionary costs, which are the costs of marketing and selling, salaries (yes, even you the boss are considered discretionary, which may be a bit of a shock), rent, equipment, maybe even legal expenses, and telephony and internet costs – in fact any cost that is not directly attributable to the product, but is more generally attributed to the business.
Fixed costs tend to be higher when you selling a product than when you're selling a service. But discretionary costs can be higher with a service, particularly with the costs of marketing and promotion.
If you sell 100 products in a month at £100 each then your turnover is £10,000 and your gross profit is £4,000, or 40%. If your discretionary costs are £3,000, then you make a net profit (before tax) of £1,000, or 10%, from which corporation tax is paid. If those discretionary costs are higher than £4,000 then you make a negative net profit. A loss.
Making a negative net profit means that you have to either sell more (at maybe a higher price) and keep your discretionary costs the same, or sell the same quantity but lower the cost of your product, which in turn will increase your gross profit, or lower your discretionary costs.
If you make a negative gross profit, then the only option you have is to reduce the cost of your product or sell it at a higher price.
It’s very important to distinguish between gross and net profit because the actions you take on each are different. In my businesses, which have been mostly selling tangible products, I would have one team focussed on continual product cost reduction, so I could either keep the same price and make more gross profit, or lower the price to get more volume. Then I'd put effort into reducing the discretionary costs by running more effective marketing campaigns, keeping the people costs in check, reducing things like travel expenses and so on.
Eventually you will need to know what kind of gross profit, or gross margin, you need to run a profitable business. My breakeven was typically around 35% gross margin and it was helpful to know this when selecting which products to sell or setting product development cost goals.
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