A friend of mine, a retired banker with lots of experience dealing with owner managers, has a phrase he uses about those business owners that he feels are in control of their business. What he says is that ‘they know exactly how much it costs them to open their doors in the morning.’ Are you one of those businesses? Many people think that this is a very difficult thing to be able to do, but in fact it’s not.
To know what it costs to open your doors, your first need to know what you will be doing when you open the doors. So you need to have a good sense of what the activities will be like the day or week. In the short term – ie next few weeks.
In most cases that will not be too difficult. You may have an order book that will tell you what will ship the next few weeks. If its retail, you should have data over the last few years that will give good guidance on what happens at this time of year.
Once you know what’s going to be happening, then you should be able to put costs on that.
The importance of a budget
A good business will prepare a budget of some sort at the start of the year. When preparing that budget, the business will develop assumptions or rules about the various costs. You will use those rules throughout the year to help you anticipate what will happen and to convert the expected activity into reasonable cost estimates.
If it’s a factory making products, the cost of the product will be made up of direct costs and indirect costs.
Direct costs are those costs that are easily linked to the product. If I am making a chair for example I can see the timber that went into that chair, I know how much timber was needed and I know what it cost. The cost of timber in the chair can be directly linked to purchases of timber.
Similarly, if it’s a convenience store, I can say that for every item that I sell, eg a litre of milk, then I must buy in a litre of milk in order to have it to sell. So the cost of the litre of milk is a direct cost. If I sell 10 litres I have to buy 10 litres. If I sell 200 litres then I have to buy 200 litres.
Labour can also be a direct cost. Even though, we can’t point to a chair and see the labour that went into making it, we might know that a workman might make 10 chairs a days. So if we have to make 100 chairs then we can calculate that we will need 10 workmen to do that. As we know what a workman costs, we can predict our labour cost.
Indirect costs or Overhead Costs
These are costs where it is harder to make the link between the individual item sold and the costs that the business incurs. For example, if I have a convenience store and I pay €1,000 rent per month. I cannot link the rent to any particular sale – there is not a direct relationship. I may sell € 5,000 worth of goods on a Monday and € 15,000 worth of goods on a Saturday but the rent cost for each day is the same.
These costs that are hard to link to a product are often called overhead costs. I think of them as costs that are hanging over the business and that vary little for different levels of activity.
Indirect or overhead costs will include marketing costs, premises costs, office consumables, staff travel, professional fee and financing costs.
In some businesses, eg a convenience store, labour costs are more of an overhead. I will have to staff my shop to a certain level even though sales for can fluctuate. For example, a restaurant will have wait staff on in anticipation of trade but the level of trade may vary significantly. For these businesses, we have to plan on having staffing levels that will not vary much will activity.
When you are doing your budgets or projections at the start of the year, you list down all the different types of overheads that you have and you put in your best estimate of what is going to happen. In that way, you pull together some sort of projection of your P&L as to what your costs are going to be.
Applying this understanding of costs
As you progress through the year, you know from your order book, or from your activity plans, what’s likely to be happening in the weeks ahead. With this awareness, you are likely to start asking yourself- “if my sales go up – what is going to happen to my materials?”
You can then predict that if your sales are going to go up by 20%, your materials might go up by 20%. If your sales go up by 20%, but the mix of sales differs, your materials mightn’t go up in exactly the same way, but if you understand your costs and you understand your sales, you will have a very good idea of what is going to happen to your materials.
Similarly, if your sales are going to go up and your activities are going to go up, you are going to have a very good idea of what is going to happen to your labour. Think back to the example about the chair making factory.
So as a good business owner/manager, you will have a sort of sense of what is coming at you and you will be quickly able to turn that sense into rough and ready figures – but reasonably accurate rough and ready figures.
Finally, you will be able to run through your overheads – certain overheads will not vary at all – rent for example. Other overheads, such as electricity, may vary. If you are running machines for longer, then you are likely to use more electricity. While some overheads are reasonably constant, there are other overheads that you will need to tweak.
You know what is happening in your business and you should be able to estimate what is likely to be happening to your overhead from that. You can do that very quickly, you can do rough numbers or you can do it a bit more precisely. For most people, it is enough to be able to do this roughly.
Building your knowledge of the business
But how do you develop this knowledge? – That is the question I am most often asked. There is definitely an element that comes from experience, but even with the experience, it all goes down to understanding the accounts and the information that you already have about the business.
If you prepare accounts every month and you spend some time understanding those accounts, and even better, if you have what I call a feedback loop, or a feedback control, you will quickly improve you understanding of what is happening in the business.
The feedback loop
The feedback loop can be summarised as Plan – Act – Review – Adjust.
We’d say that at the start of the year you make a PLAN for the business, and then you go ahead and take ACTION to deliver on that plan.
Out of that action you’re going to get results, so you look at the results, you REVIEW these results. When reviewing, you ask yourself – ‘Did what I expected to happen, happen?’, ‘Was it different?’, ‘Why was it different?’. As you review these results you’re going to get learnings. You absorb and apply those learnings and then you ADJUST your plans for the next period.
Applying Feedback Loop to Management
Putting all this together, you start off with a budget or a projection (PLAN) , you run your business (ACTION), you prepare your accounts and then you go back and see how do my accounts compare to my original budget. What was different? Aah, I misunderstood that or something changed. (REVIEW). Through this review process you develop your experience. Then you take that learning and revise your projections (ADJUST).
And that is how you develop your learning.
And that learning helps you develop a good understanding of the costs of your business, and how they relate to the activities of your business. Then you will be one of those business owners who knows how much it will cost them to open the doors of their business.
If you have any questions, or items needing clarification, feel free to drop me an email. Remember, we’re available if you want to improve your financial control expertise.