You'll need to make money to keep your business running, but understanding when and how youre making money isnt always simple.
Many businesses dont make money in their first years because it can take a lot of money to open a business (think of all the supplies, insurance, licensing fees and rent agreements you might need) and it could take some time to attract customers.
Understanding how much money your business makes and the costs associated with running the business are important for long-term success.
Find your break-even points
Your businesss break-even point is when the money you make from business sales covers your businesss expenses. While your goal may be to make money, not just cover expenses, reaching your break-even point is an important step on your path to profitability.
You can calculate the break-even point for each product or service you sell.
Using your break-even points
Once youve calculated your businesss break-even points, you can use this information along with your budget to make better business decisions. You can set goals for yourself and your staff, see how your break-even points change if you raise or lower prices or determine if it makes sense to offer a new product based on its costs.
And heres a great tip if you want to make money rather than simply breaking even add your desired profit to your fixed costs. For example, if you want to make $3,000 a month, add up all your fixed business expenses and then add in an extra $3,000. Then aim to break even with the new fixed cost.
Calculating a products break-even point
Youll need to know several pieces of information before doing break-even calculations:
- Your businesss fixed costs. The total amount of fixed expenses, such as rent or insurance, that you pay each month.
- Your average cost per product. The average cost of creating or purchasing the product. For example, if it costs you $500 to create or purchase 100 products, the cost per product is $5. These costs can be variable as materials, labor, commissions and other costs vary, but you can use the average cost per product in your calculations.
- A products sale price. How much you sell a product for. If your products sale price is lower than your average cost per product, youll need to lower your costs or increase your prices (or both) to make money.
- Your contribution margin. The sale price of your product minus your cost for creating the product. If it costs $5 to make a product that you sell for $13, your contribution margin is $8.
- Your contribution margin ratio. You can also find your margin in terms of a percentage or ratio if you divide your contribution margin by the products price. If you sell a product for $13 and your contribution margin is $8, your contribution margin ratio is 8/13 = 61.54 percent.
Here are some helpful formulas to use. For these examples, assume it costs $1,000 a month to run your business, $5 to create your product and you sell it for $13:
Break-even point in terms of number of products = fixed cost / (products price - your average cost per product)
- 1,000 / (13-5) = 125. Therefore, you need to sell 125 products to cover your monthly expenses.
Break-even point in sales = fixed costs / contribution margin ratio
- 1,000 / .6154 = $1,625. Therefore, you need to make $1,625 each month to break even and cover your cost of business plus the cost to make your product.
Profit and loss statements
A profit and loss statement, also called an income statement, revenue statement, P&L statement or simply P&L, can help you determine your businesss overall financial standing. Its one of the three main financial statements for businesses the other two are the balance sheet and cash-flow statement.
The P&L statement breaks down your income and expenses to reveal your profit over a specific period of time, such as a month, quarter, year or years. It uses a simple equation to determine this:
Income (also called revenue) expenses = profit (also called net income)
However, the P&L statement breaks down your different sources of income and expenses, helping you better understand how your business makes and spends money.
Using a P&L statement
You can find out important information by regularly reviewing your P&L statement. For example, you can compare your profits to previous periods to determine if your business is becoming more or less profitable. If you notice your businesss profits are going down over time, you might be able to quickly act and cut expenses or increase sales to remain profitable.
The P&L statement can also be helpful when youre writing or updating a business plan. You can share it with lenders when you apply for a business loan, and you can use the numbers on your P&L to help you prepare and file your businesss tax documents.
Creating and reading a P&L statement
You could create your own P&L statement, or start with a template that you can fill in. Or, if you use accounting software, the software may also be able to create a P&L statement for your business.
If youre creating your own P&L statement, you may want to use a spreadsheet. Theres a lot of addition and subtraction in the P&L statement, and a spreadsheet is less prone to errors and easier to use than doing the math on your own.
A P&L statement is generally broken down into different sections. P&L statements also use accounting terms that you might not know if you havent studied accounting before, and sometimes there are several names for the same thing.
Heres a breakdown of the terms in the order that they appear on a P&L statement and what they mean:
- Revenue/sales. The money your business makes. You can break down the revenue into different types of income, such as income from selling products and income from selling services.Theres generally a line under revenue for the money your business lost related to sales. For example, when a customer returns a product, you could include the money you returned to the customer as an expense in the revenue section.
- Net sales/total operating sales. Subtract your revenue-related expenses, such as returns, from your sales revenue to determine your net sales. Your net sales is how much money your business made from selling products and services before you take other expenses into consideration.
- Cost of goods sold/direct costs. Cost of goods sold, or COGS, refers to the costs for the materials and labor it takes to create the items you sold. This is sometimes called direct costs because its all the expenses that are directly related to creating your product or offering your service.
- Gross profit/gross margin. If you subtract the COGS from net sales, youll find out your gross profit or gross margin.
- Operating expenses/OPEX. Sometimes shortened to OPEX, a businesss operating expenses are the additional expenses that it takes to run your business. The OPEX section can be much longer than the COGS because you should include and use different lines for any expenses that arent directly related to creating a product or offering a service.Some examples are: rent, utilities, advertising, travel, training and insurance. Labor costs for employees who dont have a direct role in creating a product or service, such as a general office manager or receptionist, could also go under operating expenses.
- Total operating expenses. Add up all your operating expenses to find your total.
- Earnings before interest and taxes/EBIT. The businesss gross profit minus the total expenses. The EBIT shows you how much money the business earned before paying interest or taxes.
- Interest expenses. If you have taken out a business loan and are paying interest on the loan, you can list the interest expenses here.
- Net profit before taxes/earnings before taxes/EBT. The businesss gross profit minus the total expenses and interest expenses. Or, the EBIT minus interest expenses. If you dont have any interest expenses, the EBT will be the same as the EBIT.
- Income taxes. Add up the total amount of money the business spends on local, state and federal income taxes.
- Net income/net earnings. Subtract the income taxes from the EBT to find the businesss net income. This is the total amount of money the business earned during the specific period.
Here are two more terms you may hear in relation to a P&L statement:
- Top line. The top line is at the top of the P&L statement, and its the same as your revenue/sales. If your businesss top line is growing, it means youre selling more products or services. An increasing top line can mean your business is growing, but it wont lead to more profits if your expenses increase at the same time.
- Bottom line. The bottom line is at the bottom of the P&L statement and its your net income or net earnings. Bottom line growth means your business is making more money.
Those are the basics to a P&L statement. It isnt very complicated on its own it only requires addition and subtraction. The difficult part is making sure all the information you use is correct. To do this, youll want to make sure you have a good system for keeping business records, such as accounting software where you record every business sale and expenses.