April 2015 Newsletter

Financial Management Part 1

The Relationship Between Costs & Revenue

To be successful in business it is vital that you understand the relationship between costs and revenue.
Business owners are, by their nature primarily focused on increasing sales and spend a minimum amount of
time trying to understand the costs that drive their business and the impact on cash flow of decisions such as
price reductions to win market share.

The focus instead should always be on Gross Margin. Sales themselves are only relevant when;

 The Customer Pays

 There is sufficient margin to cover overheads
 And they deliver a net profit

Understanding Business Costs

1. Business Set Up Costs

If you are new to business or setting up a new enterprise, don’t underestimate the costs involved in getting
your operation off the ground.

Poor planning and wanting to paint a rosier picture to obtain finance or to make your idea seem more
palatable to yourself, are some of the reasons why these costs are often underestimated. This can result in
inadequate finance being obtained from your lender to cash flow your business and will give rise to cash flow
problems from the get go.

The solution is to carefully plan your business and consult with a professional accountant when preparing your
business plan. When identifying costs put them in to categories such as;

 Costs of Sales
 Administrating Costs
 Professional Fees
 Marketing Costs
 Salaries

List your costs as follows

 Start Up Expenses
 Capital Expenditure.

Remember to shop around and get value for money, equally defer any expenditure not critical to launching
your business. Second hand equipment is brand new to you, so if you can buy it second hand do so.

BMS Accountants Limited

11 Brews Hill, Navan, Co Meath.
Ph: 046 9073868.
E: info@bmsaccountants.ie W: www.bmsaccountants.ie
 April 2015 Newsletter

Financial Management Part 1

2. Fixed Costs vs. Variable Costs

We need to understand what costs are fixed and what costs are variable in our respective businesses. The
reasons for this are to help us understand what is called the ‘Breakeven Point’ of our business. That is the
point where Total Revenue = Total Costs.

Our May Newsletter will provide a working example of the breakeven point for your business.

Suffice to say here Fixed Costs are costs that remain fixed with an increase in output such as Rent, Rates,
Director Salaries and Insurance.

Variable Costs increase with output. So if you manufacture extra product you will need to buy extra materials,
labour might increase as might delivery costs.

Knowing the difference between fixed and variable costs will help you when setting your sales price as you can
determine how much margin you need to cover overheads. Equally knowing what impact a new order will
have on your variable costs will help in identifying what cash is required to finance servicing the order.

3. Cost of Sales

Sometimes referred to as Costs of Goods; Cost of Sales are those costs directly attributable to producing a
product or service for sale.

An accurate cost of sales will ensure you understand all the costs involved in producing your product and
thereby lead to an accurate gross margin.

Costs included might be; Materials, Labour, Delivery costs etc.

Remember to include only those costs consumed in the process of making a product. Any material left over is
treated as stock.

When calculating the gross margin of a product we use the following formula;

Sales less Cost of Sales = Gross Margin

If you have not included all costs in the cost of sales the gross margin will be inflated and look better than it
actually is. This could lead to poor decision making in setting new prices or lead you to offering reduced prices
to win contracts.

4. Direct or Indirect Costs

Another way of thinking about costs and to calculate an accurate gross margin is to ask yourself, is the cost a
direct cost or an indirect costs.

Direct costs are any costs that can be completely attributable to the manufacture of a product or the provision
of a service.

Indirect costs are therefore costs that are completely attributable to the manufacture of a product or the
provision of a service.

An example will help. Think of a haulier.

BMS Accountants Limited

11 Brews Hill, Navan, Co Meath.
Ph: 046 9073868.
E: info@bmsaccountants.ie W: www.bmsaccountants.ie
 April 2015 Newsletter

Financial Management Part 1

The costs directly attributable to delivering his loads would be, Diesel, Driver Wages, Truck Repairs, Motor
Tax/Insurance etc.

Indirect costs might be, Head Office Costs such as Stationery, Light & Heat, Accountant’s fees etc.

To set an accurate sales price our haulier would have to know what costs are as a result of putting a truck on
the road and what costs are not.

If the haulier wants to increase profitability then they should be focusing on reducing the Direct Costs.

5. Gross Margin

Gross Margin (GM) is the profit made on the sale of a product or service before accounting for overheads.

Being able to manage and control GM will go a long way to deciding the success or otherwise of a business.

Think of our haulier. How would you go about increasing profitability?

New customers, increase prices, decrease prices to gain new business. All of these are valid ways, however a
word of caution.

Sacrificing GM% for revenue (reducing price) should be avoided unless the increase in revenue will replace
the reduced GM%

You should always think in terms of GM%.

Review your direct costs and become more competitive.

Think…Margin! Margin! Margin!

Our May Newsletter will discuss how to compile a Breakeven Analysis for your business with a
simple working example.

If you have suggestions for future newsletters, contact raymond@bmsaccountants.ie.

BMS Accountants Limited offer complete accounting & bookkeeping services.

Contact BMS for a free consultation on 046 9073868 or 01 6859075 or email
info@bmsaccountants.ie.

BMS Accountants Limited

11 Brews Hill, Navan, Co Meath.
Ph: 046 9073868.
E: info@bmsaccountants.ie W: www.bmsaccountants.ie